Paying the price for economic mismanagement

Dr Oliver Hartwich
Insights Newsletter
15 July, 2022

We can reasonably expect New Zealand’s economy to enter recession after the Reserve Bank raised its Official Cash Rate again by 50 basis points.

No one likes being in recession, but current circumstances make it almost desirable. Accelerating price increases and tight labour markets are both signs of an overheated economy. 

The Reserve Bank therefore wants to engineer an economic downturn to let off some steam. This would relax both the labour market and consumer price inflation.

Yet, it is not as easy as it sounds.

For a start, the labour market could take a long time to return to more sustainable employment levels.

Though tighter monetary conditions will reduce economic activity and thus labour demand, labour supply might still tighten. 

That is because Kiwis are considering leaving their country. Even if only a small fraction of them move, the labour market would remain tight, despite the economic downturn. Besides, New Zealand’s restrictive immigration policies and the prospect of a recession could deter potential migrants.

With Kiwis leaving and fewer migrants coming here, labour constraints could therefore remain, even in the face of a recession. That would make the Reserve Bank’s job much harder.

However, our central bankers will be concerned about more than just the labour market.

Because next year is an election year, the Government will be tempted to soften the downturn. This might take the form of fiscal stimulus and transfer payments - but both would counteract the withdrawal of aggregate demand the Reserve Bank wants to achieve.

It is possible that the Reserve Bank would struggle to meet its goals despite sustained increases in the OCR. 

Instead, it would see the economy showing simultaneous signs of overheating in the labour market, declining economic activity and consumer price inflation. In a word: stagflation.

Some will argue that it is mainly the Reserve Bank’s fault for having led us into this mess. And they would be right. This is a recession we did not have to have.

Yet it is no good crying over spilt milk, and the real question is how to get out of it.

The Reserve Bank can only do so much. The best it can do is emphasise the return to price stability as its main goal.

The remaining responsibility for economic management, however, rests with the Government.

Demand-side management must be avoided, no matter how tempting it may seem. And in order to boost the supply side, the Government must make doing business easier and cheaper.

The Government’s economic competence will determine how long and how deep our economic downturn will be. 

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