Interview with Donald Brash
An interview with the head of New Zealand's central bank.
David Levy - Vice President
Published June 1, 1999 | June 1999 issue
Donald Brash has a steady stream of visitors to his Wellington office. As Governor of the Reserve Bank of New Zealand, he often is called upon to explain his country's approach to central banking and to discuss the market-oriented structural reforms of the economy that have occurred in the last few decades.
Early one morning, Brash spoke with The Region magazine about these topics and fielded questions ranging from the extent of his "personal" responsibility to fight inflation, to his involvement with the kiwifruit business. The interview concluded with only minutes to spare as central banker Brash swapped to his "dad" hat and raced off to his son's school Easter program.
REGION: New Zealand's central banking legislation, or the Reserve Bank of New Zealand Act of 1989, attracted worldwide interest. Why is that?
BRASH: I think it's because when it was put into place it embodied two things. One, the latest thinking about what monetary policy could do, namely influence inflation. Most central banks, including our own, including your own, have or had legislation which requires the central bank to deliver not only price stability but other objectives as well. And we had a very wide range of objectives in our legislation previously. The new legislation reflects the conclusion that most economists had reached by the '80s, namely that the only thing monetary policy can deliver in the long term is an inflation rate, and the best inflation rate is price stability. The Act was in that sense a little unusual but totally consistent with the thinking of the time-that price stability should be the goal.
I think the second factor was that, unlike central banks in the United States, in Germany, in Switzerland, and so on, we had instrument independence but not goal independence. To my knowledge, it was the first legislative embodiment of that clear distinction. In other words, the Act stipulated that the goal should be a matter for agreement between government and central bank on the appointment of the governor-which effectively means the government's got the whip-hand in terms of the goal choice-but the legislation also made it clear that the Bank was to be totally independent in terms of delivering that goal, and indeed not only independent in delivering it but accountable for delivering it. So I think those features were unusual and indeed probably unique at that time.
REGION: The system that existed before 1989 was more or less patterned after the British system?
BRASH: Yes it was. The pre-1989 legislation basically required monetary policy to deliver all good things, price stability, growth, employment growth, motherhood, a whole range of things that monetary policy isn't particularly well suited to delivering.
REGION: Something precipitated the change. Why 1989?
BRASH: As perhaps you know, we had a dramatic foreign exchange crisis in '84, not unlike some of the crises that other countries have had more recently, where we had a pegged exchange rate regime which broke down in quite a dramatic crisis. At the same moment a new government came to power, which went about reforming the economy in substantial ways, in both macro-policy and micro-policy.
The minister of finance prior to that crisis was a man called Sir Robert Muldoon, who was also the prime minister. The new minister of finance, Roger Douglas, when he came into office said to the Treasury and the Reserve Bank: I'd like to find some way of 'Muldoon-proofing' monetary policy. The central bank had been very directly under the control of the minister of finance, and the perception was that the minister had used that for short-term political objectives, which of course is a frequently-expressed concern about politically driven central banks. Douglas wanted to find some way of 'Muldoon-proofing' it. Essentially the Bank undertook quite a substantial search both of the literature and of what other central banks did. One of our key people, Arthur Grimes, traveled around the globe looking at other models, and by 1987-88 we'd come to the conclusion that this kind of goal dependence/instrument independence was the way to go. It just took a little while from that point to get the legislation through Parliament. But it was recognized from the very beginning that there needed to be a fundamental change.
REGION: The world famous Rogernomics?
BRASH: Yes. Well Roger Douglas, of course, was the minister of finance at that period, and he certainly was a key person in that change.
REGION: And unlike the changes during the Thatcher revolution and Reagan's tenure, Roger Douglas' changes didn't seem to be taken as quite as ideological. Is that correct?
BRASH: I think that's true. I don't know that one would characterize Roger Douglas as ideological in the sense that I don't think he had read extensively in Hayek or whatever. I think he was much more saying, "What we're doing doesn't seem to be working. There must be some different or better way."
I think within the Treasury, and indeed within the central bank also, there were people who were heavily influenced by Public Choice theory and were committed to making a change when they could find a minister of finance willing to listen to them. Interestingly, I don't think any of those key people had been to Chicago. Certainly none of the ones I can think of had been educated in Chicago, but there's no question that Public Choice theory and to some extent Chicago thinking had influenced those key officials.
REGION: And the changes, among many others, were to stop the farm subsidies and to cut incentives for export. Interesting concepts, but coming from a Labour Party seem peculiar.
BRASH: Roger Douglas, of course, would argue that it wasn't. He was saying: "Look, the present policy framework is not delivering benefits to the people of New Zealand." I've heard him argue that he was as much concerned about the poor people of New Zealand as he was about the affluent people of New Zealand, but he wanted to deal with that problem by introducing what are clearly more market policies. And, as you say, the policies were partly macro and partly micro. In both macro and micro, changes were very dramatic indeed. In macro, we've talked briefly about the monetary policy framework. But the fiscal side, also, was substantially changed. There was a major move to reduce the fiscal deficit, to reform the tax system, to reform the way government expenditure was done.
On the micro side, we saw the abolition of export subsidies, abolition of quantitative import controls, substantial reduction of tariffs, corporatization of government-owned businesses, privatization of government owned-businesses, etc. So it was a very extensive program.
REGION: And Ruth Richardson, the new minister of finance, then followed on the heels of these changes?
BRASH: Well, not directly. Roger Douglas fell out with the then-prime minister at the end of '88, just literally four months after he had appointed me as governor. I don't think that was a key factor in the fallout! The minister who followed Roger Douglas was in fact David Caygill and it was actually Caygill who put the Reserve Bank legislation through, not Douglas, although Douglas had initiated the process. Ruth Richardson came into office when there was a change in government in 1990.
Just on Caygill, many people have underestimated his influence on policy. He was Roger Douglas' deputy finance minister during the early part of the period and unlike Douglas himself was a trained economist. I recall his talking to me about the Reserve Bank legislation and saying, "Look, people talk about this as if the key issue is the instrument independence of the central bank," and he said that's clearly very important but of at least equal importance is the mandatory transparency of the objective and the modus operandi of the Bank. And he said that's really what protects the independence of monetary policy. Transparency constrains government also: Under the Act, government can change the target, either by mutual agreement with the governor or by overriding the agreement with the governor, but they have to do it on the table, not under the table. His argument was, and I think he was correct, the core of the legislation is mandatory transparency.
REGION: Given the breadth and depth of the overall government reform, there must have been a painful part of this whole new economic mindset for New Zealand.
BRASH: Oh, there's no question about that. The change was painful for a great many people. Clearly a lot of people lost their jobs. I think the most dramatic was in New Zealand Rail, which had originally employed about 23,000 people. Currently it employs 5,000 people.
Reductions in employment of that order of magnitude were very widespread, even in the central bank. We cut our staff from about 600 in the late '80s to about 285 at this stage. It has not all happened at one moment, but it's been a steady process of reducing staff. So it was clearly painful for many people who did not in some cases have many other skills. It was also painful, of course, for a lot of the people who had enjoyed a highly protected and privileged existence previously. In New Zealand the people who were most affluent prereforms were very large-scale farmers, who got a lot of export subsidies and so on; highly protected manufacturers, who were protected in some cases by total bans on imports; and people who owned large commercial property portfolios, all of which did quite nicely in a period of high inflation. So there were people at both ends of the income spectrum who found their position quite severely affected by the reform process.
REGION: And this process still continues. I noticed that the Crown was selling shares in Contact Energy?
BRASH: Yes. Certainly that's true. The process has slowed down somewhat, and I think that's not surprising since it's the perception of many people, and a perception I share, that in macro-policy terms most of the big changes have been made. In the micro-policy area, there are clearly things that could still be done but, again, there too a lot of the big changes have been made. But, yes you're right, Contact Energy, which is about a third of New Zealand's generating capacity, has been owned by government and is being privatized currently.
REGION: I have heard that one of the growth industries in New Zealand is tourists coming to study the way that you have reorganized your economy.
BRASH: It's true that we get a quite remarkable number of people visiting for that purpose. Even here in the central bank we'd have barely a month go by without one or two foreign central bankers coming through, in some cases from developing countries in Asia, in some cases from former Soviet bloc countries in Eastern Europe. So we do get a lot of international visitors. In some cases also from well-established central banks who are just doing things in a way similar to our own. We've had a lot of people through.
REGION: I noticed a quote from Scott Klug, a former U.S. member of Congress from Wisconsin: "Anyone who looks at privatization and government reform trends around the world tends to look first at New Zealand." Do you agree with that?
BRASH: It was a very generous comment. I'm not sure that I would claim that, but we do get a lot of international visitors. Just on that question of privatization, for example, we were clearly not the first into privatizing. I think the British probably have that claim. But there were two things distinctive about our approach to privatization, which were not those followed in the United Kingdom. The first one was that the government decided quite early on that they wouldn't privatize anything until the market in which the state-owned enterprise operated had been fully deregulated. They said they didn't want to turn a government-owned monopoly into a private-owned monopoly and then have to impose a heavy-handed regulatory regime on top of it. For example, government didn't sell Air New Zealand until it had opened the domestic skies. So we had an Australian-owned airline come in and fly around domestically, and they said that's a more effective way of ensuring good outcomes for consumers than trying to regulate any of New Zealand's prices. I think that's true of all of the privatized entities. They were not privatized until the market had been fully deregulated.
The other distinctive thing, a policy which is now being changed, is that initially at least the government said they would privatize to the highest bidder, on the grounds that if they privatized to some party other than the highest bidder, they were simply robbing the taxpayer. And for that reason we didn't initially have privatization by public share issue because the professional advisers of the government said that the best price would be obtained by selling the enterprise to a single buyer in a competitive tendering process.
One consequence of that was that I think the taxpayer did get good value from the privatization process. But another consequence was that most of the buyers turned out not only to be corporates but foreign corporates. They were the parties with the deepest pockets. And that's produced something of a political backlash against privatization. For that reason the last two or three privatizations which the government has done-the Auckland Airport, a property-owning company which basically owns the buildings government itself has occupied and thirdly this current Contact Energy privatization-have involved public share issues as well.
REGION: The Parliament has not reversed the reforms. So the changes that were made in the '80s must really be now ingrained in the psyche of the country.
BRASH: Yes and no. I think there are very few New Zealanders who would want to go back to the period prior to the reforms in areas such as the very tightly regulated shopping hours. We had monopolies, as I said earlier, of airline services and telecommunication services and so on. I don't think many people would go back to the status quo ante in those areas.
Having said that, there is I think quite a widespread perception that the reform process has in some way been socially unfair, that it has disadvantaged low-income New Zealanders and advantaged high-income New Zealanders. I think that perception is not entirely accurate. One of the origins of the perception was the tax reform of the late '80s, in which I was in fact quite heavily involved. I chaired a number of committees for then-finance minister Douglas on the tax reform process. One component of that was to reduce the top marginal tax rate, personal income tax rate, from 66 percent to 33 percent. Most people saw that as a huge benefit to a lot of fat cats, who were suddenly paying half as much tax as they had been previously. What has never been well explained to the public, and of course what the fat cats themselves aren't keen to talk about, is that prior to that change there had been a large number of tax shelters, tax loopholes, which high-income New Zealanders used extensively. Cutting the top tax rate from 66 to 33 was part of a process whereby all of those shelters were taken away. I would argue it's probably the cleanest tax system in the world in the sense that there just are no tax breaks, tax loopholes or tax shelters.
There's tax evasion of course. Tax evasion exists I would guess in most countries. But I can't think of any tax deduction for high-income New Zealanders. They don't get tax deductions for mortgage interest payments. They don't get a deduction for superannuation contributions. There is a limit of only $1,500 on the extent to which a deduction can be claimed for donations. Indeed the tax system has been simplified to the point where our so-called IR3 tax form, the form which most wage and salary earners have filled in to date, is being abolished. From next year on, this form will be discontinued because virtually no wage and salary earner will put in a return at all.
REGION: How do you score the changes in the mid-'80s up until now? What does the report card show?
BRASH: I gave a speech in London in June last year, and I was asked to speak on the question of the success of the reforms and whether they are a model for other countries. What I said in that speech was that in some respects they have clearly worked spectacularly well. One thinks of the reduction in the ratio of government debt to GDP-that ratio was rising quite strongly until about the end of the '80s, but has been falling quite sharply since. The ratio now is about 25 percent of GDP. Now that's not the lowest in the developed world, but it's among the lowest in the developed world.
The inflation rate has turned around from averaging well above the Organization for Economic Cooperation and Development average to being pretty much in the middle of the OECD pack- in the target range almost without exception since 1991. That's obviously been very successful as well. There are lots of intangible areas where the benefits have been substantial, too. I talked about shopping hours. I talked about the quality of telecommunication services, a range of things. When you look at the change in trend productivity growth, it's not nearly as obvious that the reforms have worked. You're left scratching your head about why that can possibly be the case because there are literally scores of examples of large organizations, both in the public and the private sector, operating with half or less the staff they had back in the prereform period. So it isn't quite clear why the aggregate productivity numbers don't show that up. It may be something to do with the fact that we also had a big reduction in unemployment from 11 percent to about 6 percent in the period when you'd expect to have seen the most dramatic productivity improvement. Almost by the nature of the case, the people we were bringing into employment in that process were relatively less productive than the average already employed. But what the cause of the apparently poor productivity performance is I don't fully understand.
REGION: If I remember correctly in that speech, you said you were also perplexed about the results of education.
BRASH: You've obviously read the speech. Yes. I listed two or three points which I felt were uncompleted business, and I mentioned that there were clear indications that we were not educating people well enough for a modern high-tech society. Having said that, the numbers aren't significantly different from those of the United States, the United Kingdom or Australia. So in that sense we're not worse than those countries. I just expressed the view that we should be doing much better.
REGION: Okay. Let's turn to central banking. I spoke with a few of our economists before I traveled to New Zealand. I mentioned I was going to meet Don Brash. One fellow in particular said, "Oh, this is such an interesting story because here's a governor who's personally on the line in the fight against inflation." Can you explain how that works?
BRASH: This again was part of the public sector reform more generally, where the conviction of the reformers was that there was not enough accountability for policy outcomes on the part of officials and bureaucrats. In government departments, there was a move to a formal contractual relationship between the minister in charge of the department and the head of the department, setting out the outputs that the head of the department was supposed to deliver. Instead of being on a permanent employment basis, they were put on fixed-term contracts, which might or might not be renewed and could not be renewed typically more than once. The department heads were given more discretion, hiring their own staff, firing their own staff, setting the remuneration of their own staff and so on, in a way which had not been true previously.
Now that was all going on in 1987-88 when the central bank legislation was put through. People were thinking in that mind set. If monetary policy is what basically determines the inflation rate, and if you're giving the governor explicit instructions about what inflation rate to deliver and giving him full independence to use monetary policy as he or she thinks fit, then you should also hold the governor accountable for the inflation outcome.
So the legislation that we operate under gives full decision-making authority to the governor personally, without any need to refer to the Reserve Bank's board or the minister or the Treasury or anybody else. But the quid pro quo for that is that the governor is the person who carries the can. The legislation provides for a variety of reasons for firing the governor-insanity, criminal conviction, bankruptcy and "inadequate performance" under the Policy Targets Agreement (PTA) with the government. Now that does not mean that I automatically get fired if measured inflation falls outside the 0 to 2 percent or now 0 to 3 percent agreed target. But it does mean that if inflation falls outside the target, then at least I'm at risk. This happened for the first time in the 12 months to June '95, when inflation as defined in the PTA then relevant was 2.2 percent; in other words, there was an excess of 0.2 above the 0 to 2 percent target. Throughout '96, inflation was marginally above the agreed target, culminating in inflation as defined in the PTA of 2.4 percent in the year to December 1996.
The minister of finance wrote to the nonexecutive directors on the Bank's board (whose principal function in fact is monitoring my performance on behalf of the minister) basically asking: Should we fire this guy? He didn't put it quite as bluntly as that, but that was the purport of the message. Has Brash's performance been adequate in terms of the Policy Targets Agreement? And, on each occasion he wrote, his letter was public and the reply was public, and the directors took quite a lot of care in assessing whether performance had been adequate or not. They were looking of course not just at whether the measured inflation rate had exceeded the target or not but at how the decision-making process had gone, whether the Bank had shown any (or whether the governor had shown any) wavering from the price stability objective in the process of making monetary policy decisions. And that's really the key question. You always have shocks and exogenous events which throw you off track, so the real issue is: Is the governor totally committed to delivering the agreed target?
REGION: And your success or failure at doing that, does that have any impact on the budget, the operating dollars?
BRASH: I thought you were going to say my remuneration.
REGION: Well, that too?
BRASH: Let me speak to the remuneration question first because it's a widespread perception, to some extent in New Zealand but certainly internationally, that my remuneration is inversely related to the inflation rate. Indeed, some years back I got a fax from a high school in France to say they had been sent a multiple-choice question in a national exam and the question was: The governor of New Zealand's central bank is either (a) always a previous minister of finance, (b) appointed for life, or (c) has his salary inversely linked to the inflation rate. There was no (d), none of the above! It was quite clear that the person who had sent the question thought that my remuneration was inversely related to the inflation rate. We thought of adopting that approach when the legislation was put in place but in the end decided against it, notwithstanding the theoretical attractions. The clinching argument really was that, in the process of reducing inflation from a high level to a low level, by the nature of the case, unemployment tends to go up for a time. So there was a risk of giving Brash a great six-figure bonus for delivering low inflation at the very time unemployment was peaking. It seemed to everybody that this had no public relations appeal at all, so we didn't ever do that.
In fact, my remuneration is determined by the minister, who sets it on the advice of the nonexecutive directors of the Bank. My employment contract basically provides that I'm paid on a basis comparable to the private sector. In fact when the inflation target was breached the board recommended a lower figure to the minister than they might otherwise have done, because of that breach of the target band. But it's not quite the direct remuneration link that many people have assumed.
In terms of the budget of the Bank, one of the things the '89 Act did was to deprive the Bank of the automatic entitlement to seigniorage on the currency. As you well know, seigniorage on the currency is a wonderful central banking thing which explains why many central banks, perhaps most central banks, are both grossly overstaffed and grossly inefficient. We were no exception to that. We took the seigniorage income, which in a moderately high inflation environment was always more than adequate for our needs, spent what we felt like spending and handed over the rest to the Treasury by way of dividend. There was no political oversight of what we spent. We just got first crack at that seigniorage. The '89 Act deprived us of this seigniorage. And the question then was: Well, if we have no seigniorage income and we have no minimum reserve requirement for the banks (in other words, the banks don't have to keep minimum deposit requirements with us), how secure was our income? There was no other obvious source of income for the central bank. So the Treasury's initial suggestion was: You can negotiate with the minister each year to keep some agreed proportion of the seigniorage income to cover your bread and rations. We said, well that's a pretty lousy kind of independence, if each year we have to go along cap in hand to beg for money to pay the staff. So we compromised on a five-year so-called funding agreement, and each five years we negotiate the funding for the next five years. And that entitles the Bank to an agreed amount of the seigniorage income.
Now when the first agreement was signed in 1990 with the then-Labour government, the minister, David Caygill, and I agreed that we would take the 1990 budget of the Bank and we would grow it at 1 percent per annum, the median of our 0 to 2 percent inflation target. I thought that was a pretty tough demand because inflation was still well above 0 to 2 percent-it was about 5 percent at that point actually. And it didn't give us any recognition for the fact that we had in the previous two years cut the Bank's staff quite substantially and cut out a lot of unnecessary costs. However, I signed it.
Unfortunately for me, Parliament didn't ratify that agreement before Parliament was dissolved, a general election took place and Ruth Richardson became minister. Notwithstanding the fact that I'd known Ruth for many years and regarded her as a good friend, she said, "Look there's no way I can agree to a 1 percent annual increase in resources for the Bank; I'm asking government departments to live with no increase at all." I said, "Yes, but in the case of government departments you're doing that one year at a time. This is a five-year deal. To fix this in nominal terms for five years is a heck of a lot to ask and you know a lot of things can happen in five years. That's pretty aggressive." "Sorry," she said, "I'm not willing to agree to any higher number. You believe in price stability, prove it." So with a rather heavy heart again I signed this agreement whereby we would spend no more $56.7 million-the number as you can see is engraved in my mind-for each of the next five years. It's a source of embarrassment rather than pride that by the fifth and final year of that first funding agreement, by '95, we were underspending that limit by about 38 percent. The limit for this year, 1998-99, is $40 million, which as you can see is substantially lower than the limit agreed upon back in 1990. We will underspend that limit. I'm not sure yet by how much, but it will be $4 million or $5 million under $40 million. So the inflation rate has no direct bearing on the budget of the Bank, except that the budget of the Bank is set on the presumption that prices are stable, so that if prices are not stable, we are put under some pressure.
REGION: It also seems that the funding system doesn't compromise your independence.
BRASH: I think that is right. It might be argued that a government intent on undermining the Bank's independence would seek to do it through the funding agreement. But no government so far has attempted to do that, either the previous Labour government or the present National government. Indeed, because it is so transparent it would not do the government any benefit to be seen as in some way unreasonably constraining the Bank, particularly in a situation where we've been habitually underspending the limit. Moreover, we can spend more than the amount agreed in the funding agreement if that seems necessary, with the "overspending" coming out of the Bank's reserves. To date, we have never come close to doing that.
REGION: Let's go back and define the Policy Targets Agreement.
BRASH: As I mentioned earlier, the Act stipulates that the single objective of monetary policy is "achieving and maintaining stability in the general level of prices." The next section of the Act requires that, on the appointment or reappointment of a governor, there must be an agreement between the minister of finance and the governor on precisely what that general term means for the governor's term of office. And, because I'm now on my third term, you'd think we would be on our third PTA. In fact we're not; we're on our fifth PTA.
The reason for that is that the Act also provides that the agreement can be changed by mutual agreement, or unilaterally changed by the government provided it is done transparently. It's never been changed unilaterally. It has been changed twice by mutual agreement. The first time was at the end of 1990 just after the National party government had come to office. They had campaigned on a platform which said 0 to 2 percent is the right target but getting there by 1992 is going to be too difficult. The speed of disinflation is too fast, we would prefer to get there a little more gradually and therefore we propose to change the target from '92 to '93. I felt that was entirely consistent with the meaning of the Act. Moreover, by December 1990 the Gulf War crisis was blowing up, it looked as if oil prices were going to be pretty high, and even though an exogenous shock such as a sharp increase in international oil prices could be ignored within the terms of the PTA, my feeling was that a one-year extension of the deadline would in fact be sensible. So I agreed to that. In fact we got there not in '93 nor in '92 but in '91, but that wasn't what we expected at the end of 1990.
The second time the PTA was changed was when we had an election in 1996 and for the first time New Zealand was using a German system of proportional representation. The then-National government had said that if they got re-elected they would retain 0 to 2. The New Zealand First party, which in the end went into coalition with the National party, said they wanted to express the target as an inflation rate below the average of the inflation rates in our trading partners. The compromise which they reached was 0 to 3 percent, and I was asked whether I was willing to sign an amended PTA making the target 0 to 3. Again my perception was that 0 to 3 was quite consistent with any reasonable interpretation of stability in the general level of prices and, indeed, was pretty much consistent with a lot of other inflation-targeting countries at that point. That was again a change made by mutual agreement other than on the reappointment of a governor.
So the PTA specifies the target. It also specifies the index by which the target is measured. In our case at the moment the target is specified in terms of what we call the CPIX, which is the CPI excluding interest rates. (Like the United Kingdom, New Zealand has a CPI which includes interest rates.) The PTA also-and perhaps more importantly-spells out the reasons why, legitimately, the inflation rate may fall outside the agreed target. And that's a quite important part of the PTA. A lot of the perception on the part of people who don't fully understand the framework is that the framework is unnecessarily rigid. They ask why the central bank should react, for example, to a major change in indirect taxes which affects the CPI. Surely that's crazy? Of course it's crazy. So we don't respond to that and the PTA specifically provides for that.
REGION: The target is the midpoint of the range?
BRASH: The target as expressed in the agreement is simply to keep the CPIX within the 0 to 3 percent range. We run policy to try to deliver inflation around the midpoint in six to eight quarters' time. "Around the midpoint" because running policy to have the inflation outcome close to either edge would be to live dangerously, as we discovered in the mid- '90s. In the mid-'90s we had projections which showed inflation going to 1.7, 1.8, 1.9 percent and we ignored that. In retrospect, that left us vulnerable to minor shocks.
The classic case was June '95. In May '95 we had a severe weather event-I can't now remember whether it was a flood or a drought or what it was-but in any case the price of fruit and vegetables went up about 40 percent in the month. Now that meant that the total CPI went up by some small fraction of 1 percent, but because without that we'd already been at about 1.8 or 1.9 percent it was just enough to take us over 2. Now there's absolutely nothing that could-or should-have been done about that in monetary policy terms six weeks from the end of the quarter. No amount of monetary policy tightening would have reversed that effect or offset that effect, but it made us realize that projecting inflation six to eight quarters ahead near the top of the range or near the bottom of the range is to live dangerously. So we're aiming to get the CPIX around the midpoint six to eight quarters into the future.
REGION: Here's a quote and I suspect it's from one of your critics. It says, "Dr. Brash's name is associated more than anything else in the public mind with the strategy of overvaluing the exchange rate as a means of fighting inflation."
BRASH: Yes, there's been a perception that we consciously pushed up the exchange rate to get inflation under control and that this had a severely damaging effect on the tradable sector in particular. My reaction to that is twofold. Yes, the exchange rate clearly rose, and rose quite strongly, particularly between early '93 and early '97, which is always the period my critics quote. The trade-weighted real exchange rate went up by about 29 percent and that put a lot of pressure on exporters, particularly commodities exporters who were facing weak world prices. So they were hit by both weak commodity prices and a rising real exchange rate. And that was very uncomfortable for them. I guess my second point, however, is that you can't tighten monetary policy and not have the real exchange rate appreciate if you have a floating exchange rate. And we have a floating exchange rate, and I think there are some very important benefits in that. The exchange rate did rise when we tightened monetary policy, and that's obviously one of the transmission mechanisms through which monetary policy works to control inflation.
That's true even in an economy like the United States, I suspect, where the exchange rate is relatively unimportant given the size of the domestic economy. It's clearly crucially important in countries like New Zealand, Australia, Canada, the United Kingdom and so on. So yes, the exchange rate went up. I was not seeking to drive the exchange rate up per se, I was seeking to control inflation by appropriate monetary policy. In fact it seemed to me at various times the exchange rate was patently overvalued on any purchasing power parity basis. But notwithstanding that apparent overvaluation, that's where the market set the rate and I had no capacity to change it.
REGION: There's a group of seven or eight other countries that are usually on the grid of those who target inflation. I noticed that Israel and Chile also target exchange rates. That's a decision that you made not to do.
BRASH: I'm not sure I would characterize Israel and Chile in that way. Let me talk first about Israel. My understanding is that Israel uses its exchange rate in the process of reducing inflation. And that's a different issue. Israel has sought to disinflate through using the exchange rate in a way which is not dissimilar to the way that we did in the early part of our disinflation process. In a small open economy, of which of course Israel and New Zealand are both good examples, the exchange rate has a huge impact on prices. If the exchange rate is depreciating, you're going to have upward pressure on prices and vice versa. In our early period of disinflation, we tended to look to these direct price effects of exchange rate movements to reduce inflation. We didn't intervene directly in the foreign exchange market, but we sought to adjust monetary policy to deliver an appropriate exchange rate outcome so that we could reduce inflation. The exchange rate wasn't in any sense an objective in itself. It was simply an important part of the way in which monetary policy reduced inflation. I suspect that the same has been true in Israel also. Both countries recognize that monetary policy cannot sustainably deliver a real exchange rate outcome.
I think Singapore has used the exchange rate in a similar way. Singapore sees the exchange rate as hugely important in the price formation process in that country. They're watching the exchange rate very closely for its effect on inflation. In the case of Chile, I'm not as familiar with how they operate as in the case of Israel or Singapore. [Editor's note: See The Region interview with Jacob Frenkel at minneapolisfed.org/pub/region]
REGION: I visited your Web site and noticed "our values" and "our commitment to New Zealanders." I found this really very intriguing because what I infer from it is that you're trying very hard to communicate not just to the financial institutions but broadly to New Zealanders about your activities, and to be as transparent as you can in publishing your forecasts. I suspect that makes you unique.
BRASH: Certainly we devote an enormous amount of effort to communicating, not just with the financial markets, as you say, but with the wider public. Having said that, it's much easier for me to do that in New Zealand than it is for Alan Greenspan to do it in the United States. We've got fewer than 4 million people, and it is plausible for me to talk during any 12-month period with all the key financial journalists and all the key financial writers. We have an extensive background briefing program with the media which I do personally. We had one of the wire services and one of the other main journals to lunch yesterday and we have another group today, so a lot of background briefings with the media, a lot of public speaking, most of it off the record. We find that if I'm speaking on the record, of course, financial markets expect there to be some kind of message for them in the speech and they pore over every word to see what they can find. I do probably six or eight of those on-the-record speeches a year. I probably do another 80 or 100 off-the-record speeches to Rotary Clubs, to meetings with farmers, manufacturers, church groups, anyone who will put together an audience almost, all over the country.
In the last few weeks of 1998, I did 23 meetings over 10 working days, right throughout the country, a so-called road show. This was aimed specifically at small to middle-sized businesses and was the result of a comment which a broker made to me some time back. He said, Look, you're doing a fine job of communicating with the big corporates and with the banks, but you're not getting to the small companies. I said, I can't. I don't even have a good mailing list. (We send out a couple of thousand copies, or 1,500 anyway, of all my on-the-record speeches to a wide range of addressees.) The broker said, But every small business has got a bank relationship, and every bank's got an interest in having their small business clients understand what's driving monetary policy. Ask the banks to invite their small business clients to a meeting which you host and you speak at. So we did, first in 1995 and again late in 1998. And at those 23 meetings we had just about 5,000 people, a little over 200 people on average per meeting, some of them smaller than that, some of them a lot bigger. We take public communication very seriously.
Another project, for which we commissioned a journalist, was to create a brochure on the investment implications of low inflation. We had sold price stability as a public good, and we hadn't communicated very effectively that this has implications for the way that people manage their own affairs, for savings, investments, etc. Well, we normally print 3,000 to 5,000 copies of a brochure, but we decided to go crazy and print 10,000 of these. For the first time ever we actually advertised in each of the main daily papers, just once, and the Sunday papers. Within four days the 10,000 had gone. Certainly it was free, there was no charging. I was almost embarrassed at how basic it was. But we've had to reprint it and reprint it and reprint it. We decided to call it quits at 70,000.
REGION: Communicating in that manner is something you choose rather than considering it the cost of doing business. I think so many central banks see it as the latter.
BRASH: Yes, I think we choose to do it. We choose to do it partly because we felt there was a need to explain to people. Bill Phillips was New Zealand's most famous economist, so the idea that governments have to choose between having high inflation or high unemployment is deeply embedded in the thinking of many New Zealanders. To switch from running monetary policy to help employment and growth to a single-minded focus on inflation seemed to many New Zealanders to be absolutely absurd and almost blasphemous. I mean, how can you not care about employment? So trying to explain to New Zealanders why focusing on price stability was a sensible thing to do even if you do care about employment and growth, and of course everyone does, made good sense. I think the other thing we felt was that, to the extent we could talk down inflationary expectations, we reduced the social and economic costs of delivering a low inflation rate.
REGION: Here's a quote from you: "The recovery from the Great Depression of the 1930s would have been faster if the present approach to monetary policy had been applied." How so?
BRASH: I think this is from one of our pamphlets. When a central bank takes the bottom of its inflation target just as seriously as it takes the top of its inflation target, it tends to smooth output. I think that quotation came in a section where we had been talking about Sweden's experience in the '30s. The Swedish central bank, as you may know, became the first central bank anywhere to run monetary policy quite explicitly targeting the price level. In their case, it wasn't inflation but the price level. And I think it's now fairly widely accepted that, while Sweden had a depression in the '30s, and they did have a rise in unemployment and a fall in output, and indeed a fall in the price level, if they hadn't run monetary policy very explicitly to try to offset that, they would have had a worse depression. So we've made the point in the last 18 months that, as the Asian crisis and the drought dropped New Zealand output below sustainable output, and where therefore inflation was falling appreciably, we were seeking to offset that falling inflation by easing aggressively and in doing that we were acting countercyclically. We were targeting price stability, but a byproduct of that was a tendency for monetary policy to smooth output.
REGION: You threw some cold water on the idea of a currency union with Australia.
BRASH: I have made two comments on currency unions in the last month or two. The first one was in the context of a speech I gave in Christchurch where basically I said, We had a big real exchange rate appreciation between '93 and '97 that put a lot of pressure on the tradables sector. Was that real appreciation unusual by international standards? I looked at the U.S. experience, the German experience, the British experience, the Japanese experience, and during the '90s we saw similar appreciations of all of those major currencies in real trade-weighted terms. We saw an appreciation of the Hong Kong dollar of more than 30 percent even though it was pegged to the U.S. dollar. And much of its trade, of course, is with the United States. So I came to the conclusion that it isn't obvious that linking the New Zealand dollar to the Australian dollar or the U.S. dollar or some other currency would obviate the problem of these big real exchange rate swings. So that was the first point I made. If you think currency union is in some way going to remove the problem of real exchange rate swings, you're dreaming.
Last week I was asked before a Parliamentary select committee-we appear before a select committee, as Alan Greenspan does in the United States, to answer questions on each of our quarterly Monetary Policy Statements-what I thought about a currency union with Australia. I made the point that it would clearly have some significant benefits for those companies which are trading with Australia. But trade with Australia is only slightly over 20 percent of our total trade. The other 80 percent of our trade is not helped by a currency union with Australia. I also made the point that, by the nature of the case, you can only have one monetary policy in a currency union and, while Australian monetary policy might suit New Zealand very well at times, at other times it might be totally inappropriate. For example, the Australian economy might be booming because the price of gold has gone up or the price of iron ore has gone up or the price of wheat has gone up, none of which New Zealand exports in any significant measure at all. It may well be that in those circumstances a rising exchange rate and fairly firm real interest rates would be entirely appropriate for Australia but quite inappropriate for us.
Now of course that's true in any currency union. In the United States you've sometimes got a booming Northeast and a stagnant oil-producing area. But within a single country you not only have relatively easy labor mobility but also, of course, you have more or less automatic fiscal transfers. Between New Zealand and Australia labor mobility is also high, but there are no automatic fiscal transfers. So looking at it objectively you could say, Well there are some things going for a currency union with Australia, labor mobility is one clear plus. It's our biggest single trading partner. On the other hand, it doesn't dominate our trade and there are certainly no automatic fiscal transfers. So I was really saying, "it isn't a panacea."
REGION: You have 19 registered banks operating in New Zealand, 18 of which are foreign owned. Does this create regulatory problems?
BRASH: Going back to the prereform period, we had four banks in New Zealand, three of which were foreign and one of which was government owned. So there's always been quite a strong foreign presence in our banking sector. Following the reforms, we basically opened up the banking sector about '86. We said we won't have any limits on the number of banks in the country, we certainly have no restrictions on the ownership of banks in the country, we only have prudential rules. (Unlike other countries, we haven't attempted to limit foreign banks numerically at all or in any other way.) Some nonbank New Zealand financial institutions became banks and they were then New Zealand-owned banks. Some new foreign banks came in, primarily in the wholesale end of the market rather than the retail end of the market, but they're totally free to be in any part of the market. Over the years, the foreign banks have tended to buy out the New Zealand banks. We've only got one New Zealand bank left. So there's been no inhibition on foreign investment in the banking sector, certainly since the reform process began in '86.
But to register as a bank here you do have to meet qualitative standards. We maintain the Basle Accord minimum 8 percent risk-weighted capital and some other qualitative criteria for bank registration. But we have a different approach to banking supervision than is practiced in many other countries. And in particular we have very few rules or quantitative limits on banks. For example, we don't impose any limit on the extent of single counter-party exposures. The Fed does, most bank supervisors do. We have no such restrictions. We have no restriction on the extent to which banks can incur foreign exchange liabilities or can maintain open foreign exchange positions on their books. That's totally up to the banks themselves to decide.
There are two key components of our framework. First, there is a mandatory comprehensive public disclosure of a lot of financial and prudential information every quarter, audited twice a year by the commercial bank's own auditor. And secondly, each of those quarterly statements must be signed off by bank directors saying that that information is, to the best of their knowledge, reliable and that the internal controls of their bank are appropriate to the nature of their banking business and are being properly applied.
Now in New Zealand company law, as I imagine in American company law, any director signing those statements without making appropriate inquiry puts him or herself at considerable risk. So the framework is basically built around a high level of mandatory public disclosure and director attestations, in other words, a high level of market discipline.
Unfortunately, New Zealand is not a terribly good laboratory for this approach to banking supervision because so many of our banks are owned abroad. Foreign bank parents are, of course, also monitoring their New Zealand operations very carefully. This means that no system of bank supervision is going to have a major influence on the soundness of our banks. But at the margin we believe that this use of market discipline has been effective. At very least, it has caused a number of bank directors to focus more carefully on their responsibilities.
REGION: What are the implications for New Zealand of the economic situation in Asia?
BRASH: As you know, we have a big trading exposure to Asia, roughly 40 percent of our exports of goods go to Asia, a significant chunk of our tourism is also based on Asian tourists, and the downturn in Asia certainly knocked us around quite severely. In late '96, before the Asian crisis was visible on anyone's radar screen, we were ourselves projecting a slowdown of the New Zealand economy in '98. We'd had policy very tight through '95 and '96 to get inflation back within the then 0 to 2 percent target. By late '96 we could see those inflation pressures abating, and we were projecting a period of subtrend but still positive growth in '98. By late '97 when the Asian crisis was clearly upon us, we could see that the slowdown was going to be much more significant and we started easing more aggressively.
Unfortunately for us of course we not only got the Asian crisis on top of what was already going to be a period of slow growth, we simultaneously got a drought which knocked agriculture, which knocked food-based manufacturing, and which to some extent knocked the transport sector as well. So the combination of what was always going to be slow growth, together with the Asian crisis and the drought, produced an actual recession-albeit a very brief one.
On the positive side, however, we have long had a floating exchange rate, and this has meant two things. First it has meant that the currency adjusted down as a consequence of the Asian downturn, thus spreading the adverse impact of that shock. Secondly, it has meant that our banking sector was not geared to an expectation of a fixed exchange rate. This in turn meant that, when the currency fell, the banks and the corporates were not devastated by that experience, unlike the situation in some of the Asian countries. So the banking sector is in good shape, the corporate balance sheets are in pretty good shape, and I think we got through the crisis pretty well. Witness the fact that, while we had two negative quarters of growth in the first half of '98, we've now had two positive quarters in the second half of '98.
REGION: Let's turn to some personal questions. In every one of the past Region interviews I've enjoyed asking this question: Who would be your intellectual heroes? Who are your great mentors or teachers?
BRASH: I find that a very difficult question to answer, I must say, because I can't think of any particularly dominant influences. A few years back I was asked to give a speech on the fifth anniversary of Hayek's death by the Institute of Economic Affairs in London, and I was acutely embarrassed by the fact that I had never actually read any Hayek. I did read some Hayek before I gave the speech, but I had not previously read Hayek. So I don't regard myself as being heavily influenced by any particular ideological giant of the 20th century.
I was brought up on Keynesian economics, and in fact I still recall visiting the United States as a 19-year-old in the late '50s and finding some American student who didn't believe in Keynes-and I couldn't believe it. It was just absolutely staggering to me. I mean Keynes was so evidently right that I couldn't imagine anyone who could question this. As time went on, I had a series of experiences which drove me to skepticism about the Keynesian approach to economics.
I did my Ph.D. at the Australian National University, and one of the people who influenced me considerably there was Max Corden, who was I think one of the great international economists of the second part of the century. Charlie Kindleberger was one of my Ph.D. examiners, and I learned a great deal by reading his stuff on international economics. My academic training was very much in international economics rather than monetary economics.
When I was at the World Bank, I read some works by Bela Balassa, particularly a fascinating article comparing inward- vs. outward-looking development tracks. And that had a material influence on my thinking. He compared three small inward-looking countries with three small outward-looking countries and pointed out that all six had been battered by the depression of the '30s. Three of them had decided to turn inward with more protection and so on, and three of them decided to go outward looking. One in each camp were Soviet bloc but the two outward-looking countries which were not Soviet bloc were Denmark and Norway, and the two inward-looking countries at that time were Chile and Argentina. And Balassa just showed that under every measure the outward-looking countries had done better-on growth, employment, diversification of exports, on every measure. That had a material bearing on my attitude and it shook my belief in the sort of protectionist model which I'd been to some extent steeped in as an undergraduate student.
I guess later I found Free to Choose by Milton and Rose Friedman enormously influential. I have not read much of what Friedman has written, but that particular book was very accessible and very easy to read and of course it was subsequently screened on television. That was significant in the development of my thinking in quite a range of areas, and in fact was the reason I was one of two people who invited Milton and Rose to New Zealand in 1981. So not a single person, but Corden, Balassa, Friedman, all three had pretty significant influence on me.
REGION: Do you have any advice for the Federal Reserve?
BRASH: That I won't answer! I think the Fed has done a superb job. But I wouldn't be in Alan Greenspan's shoes now for all the tea in China. I think he's got some very difficult issues facing him, particularly the risk of the U.S. economy overheating to weigh against the risk of tipping the world into recession by touching the brakes before other major economies have begun to grow more strongly. But I have to say the Fed's done a great job.
REGION: I understand you own a kiwifruit orchard and you do your own pruning. Is that how a central banker keeps his balance?
BRASH: I bought myself a piece of land to develop into a kiwifruit orchard back about 1981 at a time when buying and developing kiwifruit orchards was one of the widely used tax reduction techniques used by high-income New Zealanders, and I was at that time a reasonably high earner in the private sector. I was unusual though because, having got involved in it, and to my own surprise, I actually found myself totally fascinated by it. While most people who did it for tax avoidance reasons sold out, at quite a loss in most cases, I retained my orchard. It hasn't been a great financial success I have to say, but orcharding to me is my golf and my yachting; it's my relaxation time. Typically I spend two or three weeks a year during my summer holidays pruning on the orchard.
REGION: Is there anything that we didn't cover that you'd like to include? Themes that you might have sounded in recent days or ideas that you're working on that will be part of your speeches?
BRASH: I think we've covered most of the points. I'm glad you talked about the real exchange rate issue because that's a major question not only for New Zealand but for countries more generally. I think the recent developments in Asia have made people realize that fixed exchange rate regimes are potentially very dangerous. Certainly, running a fixed exchange rate regime and maintaining open capital markets is a recipe for grave risk, as I think has become clear. So we've got a floating exchange rate regime but also have free and open capital markets, indeed totally free and open. But that does produce swings in the real exchange rate. And of course Milton Friedman would say, So what, yes you will have a current account position which moves from surplus to deficit, but when the market gets uneasy about that the market will rebalance monetary conditions and the current account deficit will go away. I understand the logic of that and I have a lot of sympathy with it. But I think policymakers all over the world feel slightly uneasy about running policy on that basis, because if the market decides to get uneasy about the current account deficit in short order, the change in monetary conditions can be very abrupt. It can be very economically and socially disruptive.
I think the whole exchange rate regime issue, and the relationship between the exchange rate regime and capital movements, is an issue which is very much on the table throughout the world. I don't have any easy answers to it. As I say, I have a very strong preference not to do things which inhibit capital movements. We think the floating exchange rate regime has worked very well indeed for us. We haven't intervened in the foreign exchange market since March '85. I think that's the longest period of total nonintervention of any central bank anywhere. That for us has worked well. But it's an issue which many people are grappling with.
REGION: Thank you, Mr. Brash.
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