John Carran: Uncertainty in policy trumps business risks

There are doubts that US policians will compromise and put safeguards around the 'fiscal cliff' that is looming as the country's debt threatens to balloon out of control. Photo / Thinkstock

Global opportunities have gone begging, writes John Carran.

Uncertainty is a fact of doing business for companies. They have to contend with the fickle tastes of customers, unpredictable exchange rates and interest rates, vagaries of foreign markets, variable weather conditions, and shocks from natural disasters among many other risks and uncertainties. Effectively managing these risks is often the critical difference between business success and failure.

In periods of heightened uncertainty, businesses can be extremely reluctant to invest and hire. This is because there is significant benefit in waiting until the uncertainty abates before committing to projects that may not justify their cost if worst-case outcomes develop. New capital is needed to complement extra workers and produce efficiencies, so a lack of investment due to high levels of uncertainty can seriously inhibit both job growth and productivity.

These effects are pervasive in the present gloomy global economic environment. There is real doubt about the solvency of banks and countries in Europe and extreme uncertainty over the future of the euro as a currency. The impending "fiscal cliff" in the US, where tax cuts are due to expire and new measures will be needed to fix the burgeoning government deficit, is also contributing to the fug.

At the time of writing this article, politicians were about to knock their heads together to agree on major policy changes to address the eurozone debt crisis. Most have little idea before the event whether policy-makers will be imbued with the courage and wisdom necessary to stop the financial rot. And who knows whether or not partisan bickering amongst US legislators will eventually give way to workable compromises to put a fence at the top of their fiscal cliff.

But regardless, the damage has already been done - hundreds of thousands, if not millions, of working age people around the world have been cast on the unemployment heap because of the uncertainty created by poor government policies and institutions. Trillions of dollars of growth opportunities worldwide are likely to have gone begging.

New Zealand is not immune from this far-off political incompetence and dithering. Our exports are being depressed by weak demand in foreign markets directly hit by policy uncertainty in Europe and the US. New Zealand banks have to pay high costs in global markets to fund their domestic lending because globally banks have lost trust in each other's creditworthiness.

Business surveys indicate that New Zealand businesses are holding back on investment and hiring because of uncertainties in global markets related to the European debt crisis. Our country's prospects will be critically dependent on ameliorating policy uncertainty in the big economies.

As political events overseas amply demonstrate, severe policy uncertainty can easily trump most other forms uncertainty for businesses. Unpredictable changes in policy, or poor quality and unsustainable policies can create uncertainty about the regulations, taxes, and public spending programmes businesses will face in the future. These factors can materially increase uncertainty about future business revenues, costs and profits. Businesses can be reluctant to invest and hire new workers in such circumstances, and it can lead them to putting more of their financial resources into unproductive areas such as cash reserves or insurance.

Therefore, policy certainty should be an important consideration of governments.

To a certain extent risks to businesses from unpredictable policy changes are unavoidable. After all, policy-makers have to react to unforeseen events as much as businesses do. The government responses to the Canterbury earthquakes are a case in point. But it should be paramount that policies reduce economic uncertainty as much as possible given the information available. For example, we know that the proportion of elderly people in the population is burgeoning, substantially raising future fiscal costs associated with health and education. In order to plan for their futures, current workers need to know whether current levels of Government superannuation and public health services will be available when they retire; and individuals and businesses need to know whether tax rates will be materially higher to pay for this.

If these government decisions are left until the last moment policy changes will be more challenging for everyone to adjust to, which the circumstances in the US and Europe show is not a sound basis for planning.

One way policy uncertainty can be mitigated is to establish rules and transparency for politicians and government agencies to pre-commit to future policy courses. The most obvious relevant example of this, given global economic upheavals, is in the area of fiscal policy.

Here the institutions in place in the eurozone and the US have proved inadequate. Because of this government debt has blown out of control and there is no clear path to getting a grip back on public finances.

New Zealand's framework for fiscal policy, the Public Finance Act, is superior because it requires governments to be clear about their intentions and regularly report their progress. But its effectiveness still relies greatly on a political class that acts in the spirit of the Act and confronts future challenges, not just immediate concerns.

One of the important lessons to come out of European and US economic turmoil is that governments need to be honest with their citizens over the long-term costs of current policies and what needs to be done to make them sustainable. To reduce policy uncertainty, governments need to take early, and sometimes painful, actions to deal with problems before they become too large and create the need for drastic policy changes.

John Carran is a senior economist at Gareth Morgan Investments. Any opinions expressed in this column are John Carran's personal views and are not made on behalf of Gareth Morgan Investments.