Treasury has announced that it is having a major review of its macroeconomic policy framework.

No doubt there will eventually be a Treasury paper setting out their new macroeconomic policy position. Any change will reflect a shift currently going on internationally but it should be adapted for local conditions.

The statement is unlikely to state clearly the old policy framework. Yet there is a need to be reflective. Keynes said ‘Practical men [and women] ... are usually the slaves of some defunct economist.’ In practice the defunct theory will be overlaid with adaptations and fudges which have had to be made in the face of reality, but we carry its foundations deep in our thinking. It is evident, particularly, in much of the ‘expert’ comment which is quite unaware of its dependence on a failed theory. We cannot avoid that slavery without being explicit about the obsolete framework. So let me try to set it out.

In the late 1980s and early 1990s there was a revolution in our macroeconomic policy. The big change was the assumption that demand management – government spending, taxation and borrowing had little significant impact on the economy. It could not, for instance, change the level of unemployment much. That requires, it was said, supply-side measures like cutting the unemployment benefit, as happened in 1991, to give the unemployed a greater incentive to find a job. (The policy did not have much effect.) Wages had to be kept low relative to productivity in order to maximise jobs.

The framework assumed that short-term interventions did not work because the government was too clumsy. Interventions to smooth out the business cycle often reinforced the swings because they took so long to become effective. This was because the thinking was hugely influenced by American analysis based on the inertia in its government’s policy process. However our government arrangements are quite different and new policies can be quickly developed and implemented, as illustrated by the package at the beginning of the March-April 2020 lockdown.

Nor, said the framework, should we be concerned with the external deficit or overseas debt, providing the government was not borrowing overseas. Private debt was a private arrangement and of no concern to the government. What the analysis overlooked was that commercial bank offshore debt is different. As the Global Financial Crisis demonstrated, commercial banks can have recourse to the Reserve Bank, which means that the government may have to bail their foreign borrowing out. Today offshore commercial bank debt amounts to about 50 percent of annual GDP, up from about 10 percent in 1990.

The logic of the framework was that fiscal policy was neutered. Its predominant concern was the size of the government debt. The smaller the better. The result of this concern was a section in the Fiscal Responsibility Act (now incorporated in the Public Finance Act as Section 26g), which sets out a public debt management target. What it actually says is incomprehensible; I have seen a room of economists tying themselves in knots trying to work out its meaning; had lawyers been there too, the knot would have been truly Gordian. Ministers of Finance cut through by ignoring it.

Even so, the section gave the impression that the level of government debt was all that mattered for fiscal policy. You will recall Grant Robertson in opposition made a promise about low debts levels. Faced by the Covid Crisis, he claimed unusual circumstances (as Bill English had done in 2008).

Suppose the government had to bail out a vital New Zealand business – as Michael Cullen did with Air New Zealand and Transrail, following inept private sector management – or it built and owned state houses funded by borrowing. In each case there is a jump in the amount of government debt but it is offset by a jump in revenue-generating government assets. What matters is the quality of the overall government balance sheet, not some line in it.

Admittedly it is easier to stupidly focus on a single number. (When did you last see a serious discussion on balance sheet quality?) That does not mean we should ignore the amount of government debt – those lending to the government will not let it. But it is but one of a set of measures we should use to judge the fiscal position and it has to be evaluated in a total context including, especially, the offshore commercial bank debt.

The old framework, having written off the role of fiscal policy in managing the economy, gave the active macroeconomic role on the Reserve Bank and its management of monetary policy. Again this partly reflects American institutional arrangements for its equivalent (the Federal Reserve) has far more flexibility than the US Congress.

I agree that the RBNZ should have operational independence on monetary policy. We don’t want a politician ringing the governor up directing what they should do. (Robert Muldoon used to.) But the rest of the monetary policy in the old framework only made sense if fiscal policy was impotent. I am not going to develop my analysis here which sees monetary policy by itself as relatively ineffective, taking a while to impact on the real economy (the impact on financial markets is faster). Instead I’m going to use the framework which the Treasury and many other economists use. Apologies for the simplifications.

The idea all those years ago was that the RBNZ set the interest rate to stabilise prices; that was all it could do. So the RBNZ was charged with maintaining a low inflation target. However in recent times the base interest rate has become so low that it is increasingly ineffective in the management of the economy. (In the jargon it is at or near the ‘zero lower bound’.) The analysis was first developed by Keynesians some ninety years ago with the conclusion that direct fiscal management was necessary.

Allow me to skip a discussion on a range of ‘unconventional’ monetary policies – such as ‘quantitative easing’ – which have been used since the GFC to deal with these very low interest rates. They were particularly necessary because fiscal policy was often ruled out (albeit not in every case). While they worked in the short term, there is much unease with the enormous liquidity that has been injected into the economy. The old framework says the measures are inflationary. While inflation has yet to occur, there is far too much liquidity swilling around and something disastrous is likely to occur in financial markets.

In any case, the Covid Crisis found monetary policy not very effective and almost every country added fiscal policy to cope with its economic consequences. (To be fair to the old framework, it was never designed to deal with a supply-side shock of this magnitude.)

So the New Zealand Treasury, and just about everyone else (I exclude much of our commentariat), is struggling with how to think through what next, but is hampered by the detritus of the defunct economics from thirty-odd years ago. I’ll try to keep you informed when (if) things become clearer.