Peter Lyons: Monetarist ideas cost us dearly

Money can be regarded as a commodity just like tomatoes. The suppliers of money are lenders such as banks and finance companies. Their customers are borrowers. The price of money is the rate of interest.

If the Government set a guaranteed price for tomatoes of $20 a kilo, New Zealand would soon be awash in tomatoes.

The Reserve Bank of New Zealand has set a high interest rate for money compared to overseas interest rates. Consequently New Zealand has an abundance of easy credit. Unfortunately, this credit is not cheap.

Finance Minister Michael Cullen has requested Treasury and the Reserve Bank to explore measures for controlling the price of inflation in the housing market. Solutions that have been floated include restrictions on lending ratios and even the vague possibility of a capital gains tax.

But no mention has been made of the fact that the operation of monetary policy itself may be contributing to the housing bubble.

The Reserve Bank is required to keep inflation between 1 and 3 per cent. New Zealand pioneered the use of an explicit inflation target.

The Reserve Bank sets the official cash rate to achieve this target.

The official cash rate (OCR) is the base interest rate for the economy. If the OCR increases then most other interest rates also increase. This should reduce the level of demand in the economy and prevent price rises.

This method of operating monetary policy has created a benevolent trading environment for banks, finance companies, mortgage brokers and other lenders.

If tomato growers had the same degree of certainty about the price at which they could sell their tomatoes they would be rubbing their hands in glee.

Movements in the OCR are reasonably predictable. When inflationary pressures are pushing the top end of the inflation target range it is more than likely the Reserve Bank will increase the OCR.

This allows banks and other financial institutions to get their funds at lower interest rates from overseas and pump this money into the New Zealand loans market at the higher rate.

This has been a major contributing factor to the surging house prices in recent years. People continue to borrow to buy houses regardless of the higher interest rate. Some borrow for speculative reasons but many others just want to own the roof over their heads.

Alan Bollard, the Governor of the Reserve Bank, has lamented the actions of banks and other lending institutes as being mercenary and disregarding the long-term consequences of their lending practices. This is like the Minister of Health suggesting that cigarette companies cut back production to improve health statistics.

The operation of monetary policy by the Reserve Bank is a key contributing factor to the easy availability of credit in New Zealand. This is fuelling the housing inflation. To a large extent we are using overseas funds to bid up our own house prices and creating huge profits for banks and other lenders in the process.

Having such an explicit inflation target provides financial institutions with an easy trading environment that few other businesses in New Zealand enjoy.

Economic history contains several orthodoxies that have not stood the test of time. Before the Depression in the 1930s, classical economists believed that an economy would always gravitate to full employment in the long run.

John Maynard Keynes famously stated that in the long run we are all dead. He advocated government intervention though public spending to create demand to ensure full employment.

After the Depression and World War II, Keynesian economics became the new orthodoxy in many countries. Through to the 1970s, Governments tried to manage the level of demand in the economy to ensure full employment.

Keynesian economics was undermined by the inflationary pressures of the 1970s and 1980s. Governments sought to reduce unemployment by increasing spending. But firms and unions, anticipating inflation, increased their wage demands and raised their prices, leading to an inflationary spiral

In the 1980s and 1990s many countries adopted monetarist policies to battle this inflationary pressure. Inflation became public enemy No 1.

Controlling the money supply, credit and interest rates was regarded as the best way of curbing inflation. Low or no inflation was a key goal of macro policy regardless of the costs. New Zealand became an advocate of stringent monetary policy to control inflation.

It may now be time to question this monetarist orthodoxy. It is starting to cost us dearly.

The influx of borrowing from overseas has overvalued our exchange rate against our trading partners. This is slowly throttling our export sector.

In providing such a favourable trading environment for banks and other lenders, our stringent monetary policy has also contributed to a debt mountain and rocketing house prices.

Rather than exploring clumsy methods for reigning in house prices, the Finance Minister should be inviting an examination of the costs and benefits of maintaining such an extreme monetarist approach to managing the New Zealand economy.

* Peter Lyons lectures in Foundation Studies at Otago University.