Keith Rankin Analysis – The Two Policy Silos: Reserve Bank and Treasury

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Analysis by Keith Rankin.

Macroeconomic Policy

Macroeconomic policy is largely the art or science of the governance of economic imbalance. Some of the words that indicate imbalance are ‘recession’, ‘inflation’, ‘deflation’ and ‘contraction’. Another word, ‘stagflation’, represents a mix of recession and inflation. (Note that ‘inflation’ here indicates an unsustainable and ongoing process of price increases, not simply the latest percentage measure of increased prices.)

At the extreme end, the main identified examples of imbalance are ‘depression’, ‘balance-sheet recession’, and ‘hyperinflation’. These are not simply extreme versions of normal recessions and normal inflations; they have some fundamental differences. This means that regular policies that seem sufficient to correct ordinary recessions and inflations are not sufficient to correct balance-sheet recessions or hyperinflations, and may even aggravate those conditions.

The word ‘depression’ is a non-technical term that is not a part of the formal lexicon of economics. And the term ‘balance-sheet recession’ – while a technical term – is new to economics, and is not well understood by many economists. The word ‘contraction’ tends to be used by macroeconomists as a synonym of ‘recession’.

The world is at present in a balance-sheet recession. Leaving aside events pre-1900, there have been three previous balance-sheet recessions: the Great Depression of the early 1930s (which had its roots in the 1920s), Japan’s recession of the 1990s, and the Global Financial Crisis (GFC) of the late 2000s and early 2010s. (While New Zealand’s experience from 1987 to 1993 had all the hallmarks of a balance-sheet recession, the global context and New Zealand’s small size offered a number of ‘safety-valves’; enough to make the experience seem less intransigent than that of Japan.)

The two macroeconomic policy ‘levers’ are called monetary policy and fiscal policy. With the exception of the International Monetary Fund (IMF) – which has limited powers – all macroeconomic policy is conducted at the national level; however, the bigger a nation’s economy the bigger are the global impacts of national policies.

In practice, it is widely understood that the two most important globalmacroeconomic policy silos are the United States’ Federal Reserve (central bank) and the United States’ Treasury. Since the 1980s the convention of ‘best practice’ is that Reserve Banks and Treasuries should act as silos; that is, they should be fundamentally independent of each other. Indeed, the establishment of this global ‘best practice’ owes much to New Zealand, and was epitomised by the New Zealand Reserve Bank Act of 1989.

In New Zealand, the Two Silos are easily envisaged as silos: two large multi-story buildings in Wellington of 1960s’ vintage; 1 The Terrace (the Treasury), and 2 The Terrace (the Reserve Bank). The two lever-pullers are the Minister of Finance (who, here, I will call the ‘Treasurer’), and the Governor of the Reserve Bank. The current level pullers are Grant Robertson (Treasurer) and Adrian Orr (Governor). We may also note that, in part because Grant Robertson has had minimal academic training in economics, he is more attentive than many past Treasurers to the advice of the Treasury Secretary, who since 2019 has been Caralee McLiesh. (She is the Treasury equivalent of the Ministry of Health’s Ashley Bloomfield, who is now an iconic public figure in New Zealand. While she is New Zealand’s first female Treasury Secretary, New Zealand has had a female Treasurer, Ruth Richardson, whose tenure in the early 1990s led to the epithet Ruthanasia.)

The Two Silos – while physically close – are statutorily independent from each other. The Reserve Bank conducts monetary policy. The Treasury conducts fiscal policy.

Monetary Policy and Fiscal Policy

In the 1920s – the epic age of emergent central banks – monetary policy was king. After the Great Depression, the emphasis switched to fiscal policy as the principal macroeconomic lever. In the late 1970s – the second half of the 1980s in New Zealand – the emphasis switched back to monetary policy as the correct lever to use. While in some other parts of the world this century fiscal policy has revived – eg Japan – New Zealand remains a laggard in looking only to monetary policy as a means to address recessions. (China, we may note, has never disavowed fiscal policy; and it was China’s fiscal policy that got the world out of the most recent pre-Covid19 balance sheet recession. China, however, is dominated by a big powerful government, and that fact in itself helps to deter western policy analysts from advising policy responses that smack of big government.)

Here, I will stick to ‘expansionary’ or ‘easy’ policies as remedies for the condition commonly called ‘recession’. (That is, I will avoid discussion of ‘tight’ or ‘contractionary’ policies as remedies for inflation.)

Monetary policy is a treatment that results from a diagnosis of ‘recession’. Critical symptoms that may trigger the policy are: annual inflation rates below one percent, unemployment above five percent, annual economic growth below two percent. The principal policy action is to reduce interest rates; in particular in New Zealand to reduce the Official Cash Rate (OCR) which is effectively the rate used by banks to borrow money from and lend money to each other. The aim of monetary policy is to increase spending in ‘the marketplace’ (my preferred word to ‘the economy’) by increasing household spending (through less saving and debt repayment, and more household borrowing on consumables and house-building) and by increasing investment spending by businesses (and governments) through more borrowing. Thus, the conditions are created whereby the commercial banks create and lend new money; this is called increasing the money supply. This is a process of attempting to inject money into the marketplace.

In more extreme cases – and in general in the United States – the money creation process must be conducted through an explicit expansion of the central bank’s balance sheet. This is now called ‘quantitative easing’, and is an entirely orthodox process.

There are two main problems with monetary policy; both are problems that can be resolved through coordinated fiscal policy. The problems are: first, some of the money might not be injected into the marketplace; instead much of it may be injected into ‘the casino’ which is my preferred term for ‘secondary financial markets’. There are secondary financial markets in shares (equities), bonds (promises, including government bonds), land (real estate), commodities (eg gold and silver), financial derivatives, cryptocurrencies such as ‘bitcoin’, and certain scarce items such as artworks. An important route in New Zealand whereby money ends up in the casino is through KiwiSaver retirement ‘savings’ accounts. The second problem is that much new money may just sit on the Reserve Bank’s balance sheet, injected neither into the marketplace nor the casino.

Monetary policy – as understood by most of its advocates – has a ‘right-wing’ bias. (More about this later.) In particular it emphasises the role of lower interest rates as an incentive to increased private-sector borrowing as an injection mechanism, and thereby deemphasises government borrowing as an injection mechanism. The problem arising from this bias is that much private-sector borrowing goes directly into the casino (which is inherently private) rather than into its intended destination (the marketplace). Further, too many people with right-wing predispositions – non-economists and economists alike – do not see the casinoisation of the economy as a problem.

Under certain conditions, the extent of casinoisation is enhanced. When interest rates are seen as very low, more people purchase ‘financial assets’ which they hope will appreciate in price – that is, assets traded in financial and related markets – rather than putting money in the bank. And when interest rates are too high, commercial banks regard much business lending as too risky, and prefer lending to speculators with collateral than to businesses which produce goods and services.

Expansionary fiscal policies take place when governments decide – as a recession-correcting device – to decrease their budget surpluses or (more commonly) increase their budget deficits. Fiscal policy is often constitutionally monopolised by centralgovernments, with local or state governments having little policy discretion and generally having to borrow on similar terms to businesses. In New Zealand, fiscal policy is constrained through a highly political clause in the Public Finance Act; a clause which came into being as the 1994 Fiscal Responsibility Act – its architect was then Treasurer, Ruth Richardson.

There are right-wing and left-wing versions of fiscal policy. The right-wing version is to cut taxes; and, in some countries, to expand military spending. The left-wing version is to increase government outlays on social programmes such as healthcare, education, social security transfers, and social housing. The right-wing version has the same drawbacks as monetary policy; it tends to put more money into the casino directly, or indirectly via debt repayment with new bank loans favouring the casino. This tendency is exacerbated in a society with high income inequality, or when the beneficiaries of tax reductions are largely the people who have the fewest unmet economic needs.

The cost of a pure fiscal policy is higher interest rates. This is because Treasuries must finance their bigger deficits by borrowing (from financial intermediaries) in competition with private-sector borrowers. (Or, in the case of reduced government budget surpluses, interest rates go up because governments are not lending as much as before to financial intermediaries.) The other cost – of principal concern from a right-wing perspective – is that, with more government spending, governments play a bigger role in determining resource allocation (ie, determining which goods and services will be produced). The essence of right-wing thinking is that governments should not be ‘big’.

Right Wing Economists

A right-wing economist is an economist who has a philosophical preference for a marketplace dominated by private rather than government ‘actors’. That is, right-wing economists favour small powerful governments over big powerful governments. A right-wing economist is not necessarily a person who votes for right-wing political parties. (An Australian friend of mine is a well-established right-wing economist, but commonly prefers the Australian Labor Party.) This means that right-wing economists tend to have a philosophical preference for monetary policy over fiscal policy (although a popular brand of right-wing economics in the 1980s – supply-side economics – emphasised tax cuts over monetary policy).

(Defining a left-wing economist is harder. A conventional definition of a left-wing economist would be someone who emphasises ‘market failure’, and favours a substantial role for government in addressing market failure. While this role could include a preference for fiscal policy over monetary policy, most left-wing economists instinctively look to higher taxes – and tax scales that are more graduated – rather than higher budget deficits as means to finance government spending. I regard myself as neither a right-wing nor a left-wing economist. Rather I would say that I am politically centrist, though heterodox – rather than orthodox – in that I try to look for unconventional solutions within the established discipline. I am not an anti-economics economist, though there are such people.)

Two examples of right-wing economists in New Zealand are Michael Reddell and Eric Crampton; both are excellent economists who favour small powerful governments over big powerful governments. Both were interviewed recently on Radio New Zealand. (Refer ‘We’ve clearly not had enough policy stimulus’ [23 Aug], and Do Kiwis Understand the Electoral System? [25 Aug]; less than half of the latter item is about the electoral system!)

To a non-right-wing economist, Reddell’s position in the interview seems strange; Reddell argues that New Zealand has – so far during the Covid19 pandemic – experienced a large fiscal stimulus and an inadequate monetary stimulus. In fact, while the fiscal outlay is large compared to any previous fiscal stimulus, much of the money available may remain unspent, and the government is showing reluctance to augment that outlay despite this month’s Covid19 outbreak. And, as a particular example, the government keeps pouring salt into the running sore that is the Canterbury District Health Board’s historic deficit (see here and here and here and here); the Minister of Health showed little sign of compassion towards the people of Canterbury when questioned about this on yesterday’s Covid19 press conference.

Further, monetary policy has been very expansionary. In its recent Monetary Policy Statement (and see here), the Reserve bank has committed to ongoing expansions of the money supply through quantitative easing. Because the Reserve Bank must act as a silo, however, it has to participate in the casino (the secondary bond market) to do this; perhaps a less than ideal way to run monetary policy. Reddell has too much faith in the ability of the Reserve Bank to expand business investment spending.

Reddell is a committed supporter of negative interest rates – indeed he cites the same American economist, Kenneth Rogoff, who I cited in Keith Rankin on Deeply Negative Interest Rates (28 May 2020). This call for deeply negative rates is tantamount to a call for negative interest on bank term deposits and savings accounts; that is, negative ‘retail interest rates’. While Reddell does not address the issue in the short interview cited, Rogoff notes that an interest rate setting this low would require something close to a fully electronic monetary system to prevent people withdrawing wads of cash to stuff under the bed or bury under the house.

One difficulty here is that – prior to Covid19 – there was probably an equal chance that the world would face an electronic pandemic as a biological pandemic. (New Zealand’s stock exchange this week is suffering from electronic infection; for the third day in a row trading has halted by “volumetric DDoS [distributed denial of service] attacks from offshore on 25 and 26 August” (NZ Herald, 27 Aug 2020: NZX halts trading; website down for a third day in a row). In the event of an electronic viral pandemic, business would need to move to a more manual mode of operation. As it is, we have moved to much less-manual modes of operation, making the potential consequences of electronic viruses all the greater. If our entire monetary system is dependent on the infrastructures of the internet, then we become very vulnerable to malign ‘hacking’ attacks.

Nevertheless, Michael Reddell has a point, and we need to stop seeing interest payment on savings as an entitlement. What I would like to see is the recalling of all $50 and $100 NZ banknotes (to flush out criminal and other cash hoards), with the maintenance of lower denomination notes and coins, and the ability for businesses to perform manual credit card transactions. These forms of money can be used when the power supply or the internet are ‘down’, and small cash remains a convenient alternative for small transactions.

Recessions versus Balance-Sheet Recessions

A ‘normal’ recession or contraction can be defined as a downturn that can be corrected through well-tried monetary policy techniques, and without the need for complementary fiscal policy. One enhancement for this policy recipe would be that governmental organisations – including universities, polytechnics, local governments and central government – should be free to respond to these normal monetary policy incentives. That is, they could be freed to respond to monetary policy in the same way that businesses are expected to respond, and would be no more debt averse than private businesses are. This would mean that fiscal policy should be defined as an autonomous increase in government borrowing, separated from an increase in spending induced by monetary policy.

On the other hand, a balance-sheet recession is one in which substantial numbers of otherwise viable businesses have become insolvent, whether by a shock such as Covid19 or by a speculative mania such as that which struck Japan around 1990.

In a balance-sheet recession, monetary policy becomes ineffective because businesses and governments are prioritising debt reduction; and just about all potential borrowers have become completely insensitive to interest rates. It means that, under these circumstances, it is almost impossible for the Reserve Bank to inject money into a marketplace which is desperately low on cash flow. The main role of monetary policy, unintended, becomes to rescue the casino; money that cannot take one path will most likely take the other path.

A balance sheet recession requires an autonomous fiscal policy response; preferably a fiscal policy that is coordinated with monetary policy. The silo mentality gets in the way of finding a way out of a balance sheet recession. In New Zealand’s present case, when the Reserve Bank creates the new money, it is essential that the government spends it, or otherwise distributes it to the people who will need to spend it to avert collective impoverishment. The central government’s balance sheet is by far the most effective vector for injecting money into the marketplace.

The Great Depression

There is still no academic consensus about the causes of and recovery from the Great Depression of the 1930s. Certainly, many economists who know little of the actual history of that event have certain favourite beliefs about this. For those economic and other historians who have studied the Great Depression, there is a widespread acceptance that there were failings of both monetary and fiscal policy. It is also widely accepted that the analysis of John Maynard Keynes – my preferred candidate as the most important human of the twentieth century – emphasised the failure to deploy appropriate fiscal policy.

Right-wing economic historians – and I would include Milton Friedman here as the best known – emphasised failings of monetary policy, claiming that, when monetary policy was eased in the United States it was not eased enough and was eased too late. Friedman believed that if Benjamin Strong – the capable American ‘Governor’ (Chairman of the Federal Reserve) – had not died in 1928, then the Great Depression would have been a normal short-lived recession. This analysis is simplistic, in the extreme.

The main problem was that the fiscal policies that just about all governments adopted during the Depression were the exact opposite of the fiscal policies required. Governments responded to their reduced revenues by reducing their spending, aggravating rather than offsetting the depression in the private sector.

Eventually fiscal stimulus did resolve the Great Depression. In New Zealand a critical role was played by the First Labour Government, which used coordinated fiscal and monetary policies from 1936. In addition, the massive devaluation of New Zealand’s currency (in two stages: 1931 as an adjunct of sterling’s collapse, and in 1933) rebuilt New Zealand’s trading economy. From a global perspective, however, it was only World War 2 that provided sufficient fiscal stimulus to end the Great Depression. There has got to be a better way.

In those days – the 1930s – there was very little academic expertise for governments to call upon. They took advise from people who had no understanding of what their economies were up against. In 2020 we have the clear evidence of the eventual role of fiscal policy in resolving Japan’s balance-sheet recession. And we can see that ‘fiscal stimulus’ from most national governments got the world economy out of the first wave of the Global Financial Crisis, and that fiscal stimulus from China got the world economy out of the second wave of that global crisis.


It is very discouraging to witness a New Zealand Labour-led government whose rhetoric and inaction is so intransigent towards the benevolent use of fiscal policy; a government that refuses to learn the principal lesson from the Great Depression, and appears to observers that it would rather facilitate another great depression than give up its present intensely conservative understandings of the workings of public finance. While the Governor is doing his job, the Treasurer so far is not doing what he needs to do to render monetary policy effective. (And I note that I have seen nothing in the last few weeks to suggest that a National-led government would be any more willing to escape from the fiscal straitjacket of the Public Finance Act.)



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