Less is more in risky times

Think the economy is great? Independent economist BRENT WHEELER deflates the global bubble.

The New Zealand economy is on a roll. But the global economy is sluggish and unlikely to spring back quickly. The happy state of affairs for New Zealand will not continue indefinitely. This obliges us to examine the increased risk responsible for the world's economic performance and prospects.

While New Zealand basks in the past few years' GDP, employment, CPI and tax-take figures, arguably some of the biggest changes in economic risk since World War II are taking place. These involve deep-seated issues and some difficult problems, the solutions to which are beyond the reach of left, right and third-way governments.

Inevitably New Zealand is becoming more enmeshed because four related factors - terrorism, markets moving together, investment monitoring problems and the threat of deflation - have joined forces and driven up risk.

Coming to a neighbourhood near you

Being Europe's most distant butchery, dairy and fruiterer has served New Zealand well for more than a century. And that distance has delivered security and the luxury of being able to ignore distant conflict. September 11 and subsequent events changed that.

The World Trade Centre tragedy, in the very heart of the United States, showed that terrorism has no respect for geographic advantage.

Events in Bali reminded the world that Asia is home to millions of Muslims, with more than 160 million in Indonesia alone. It showed, too, that icons of western civilisation, as much as western wealth, are the targets.

On these grounds alone, scoffing at security risks around the America's Cup is unwarranted. On investment grounds it shows that risks associated with terrorism are ubiquitous. Mere disarming of Iraq or taking out Saddam is not the complete solution.

New Zealand, while arguably safer than most in a risky world, is no longer immune purely because of its location. Safer haven perhaps. Safe haven, no.

The country's burgeoning tourist industry faces costs from the perceived tourist travel risk that the Bali tragedy highlighted. A stumble in this sector is doubly costly, as it hits tourism earnings and threatens the diversification of New Zealand's economy.

New Zealand will not escape the risk premium laid on by investors because of terrorism and unsettled international relations.

When markets link arms

Diversification is the most basic and reliable plank of successful investment. Like compound interest, its logic is infallible.

But it depends on all markets not moving in the same direction at the same time - the logic of investing in both the umbrella and ice cream market. In fact, it relies on some markets moving in opposite directions at the same time or at least one market staying on an even keel.

When this doesn't happen markets become correlated. They move in lock step and there are severe problems. Recent events have created such a situation. Widespread uncertainty has created bear markets for umbrellas and ice creams.

Worse, investors seeing this all try to bail out at once. Buyers disappear so liquidity dries up. The price spread between willing seller and willing buyer gapes open, leaving investors saddled with depreciating assets they can't quit except at mind-numbing discounts such as the 40 per cent drop in the S&P 500 US equities index experienced so far this year.

Markets moved in lock step in the 1930s, in 1987 and after the Russian devaluation in 1998. Each time investors were crunched. So too in 2000.

Impotent monetary policy

Monetary policy settings provide no easy fix. The US Federal Reserve gave them its best shot with remorseless loosening all the way down to 1.25 per cent, but to little effect. Now the scope, in the US at least, is virtually gone.

The best economy-wide measure of inflation, the GDP deflator, fell by October to 1.1 per cent, so with the federal funds target (the equivalent of our official cash rate) at 1.25 per cent, real interest rates must be around 0.15 per cent, barely positive. Returns above that simply seek to offset risks.

Two problems bedevil monetary policy instruments. First there is almost nowhere left to go: 0.15 per cent real is as low as it gets. Second, and exacerbating this problem, successive downward adjustments of discount rates tend to produce successively smaller positive reactions. The Fed has become more aggressive in loosening monetary policy, but markets barely flutter.

Private credit and deflation - a bigger problem made worse?

Problematically, lower discount rates drive down costs of consumer credit. Stimulating the economy like this makes it easier for private debt to grow. Economic stimulus frequently comes from consumer spending financed by private-sector credit. This powers growing whiteware, television and DVD sales and the booming retail PC market.

Fine perhaps when real interest rates are positive and inflation is eroding debt, at least in the short term. Not so clever should deflation set in, even in mild form.

Deflation works in the opposite way to inflation. The debt burden swells rather than shrinks. The only way out is through seriously cutting back on spending and selling assets.

Problems with investment instruments

Along with problems of where to invest are problems with what we invest in. Governance scandals abound and the problem is damnably stubborn given the current regulatory tools.

The Enron, Global Crossing, and Tyco fiascos emerged from the most regulated capital market in the world - the US - where regulators had by repute eliminated the "cowboys" who apparently pervade only New Zealand markets.

Advocates of more regulation in New Zealand spent decades claiming that regulated markets in the US, Britain and Europe are sophisticated and civilised. But corporate disasters reveal something radically wrong with the idea that enough regulators implementing enough rules will suffice.

Equally flawed is the good guy notion underpinning this. That all of the thousands of employees of accounting firms like (the late) Andersons are crooks is as patently absurd as the idea that more "good guy" government would solve these problems.

Enron, Global Crossing and others show that it is our accounting, not our accountants, that is the problem; our auditing, not our auditors, and our regulating, not our regulators. For investors, these disciplines have not delivered.

This all drives more risk into investing. Governance risk and agent-principal risk seem now to be inherent in investing. They may have, probably did, exist all along. What is different is investor awareness on a scale not seen in the past.

What can governments do?

Not much is the truthful answer - and they ought not to be blamed for this reality. "Lead us not into temptation but deliver us from evil" is as good a policy as any. Monetary policy remains strictly limited in what it can achieve. Regulation of capital markets promises delusion and cost.

Policy and regulation cannot shield investors from risk. Assets must come to reflect their true value given new risks. Regulatory barriers should not impede this process or competitive responses such as capital raising, mergers and takeovers.

Driving down costs of business and costs of reconstructing with new businesses require a hawkish approach to resource management policy, initiatives such as the Kyoto protocol, and to confrontational labour market policy. Less is likely to be more as risks grow.

Finally, governments can recognise that cash is master and mistress in risk management. That means fiscal prudence and high-quality government spending are in while blanket prohibitions on regulatory and tax reform are out.

Herald special report: