©Wilson Gan, Economics, U of Auckland, May 2009
The recent global economic crisis is causing the world’s economy to contract. This has caused a major economic downturn for the US; is New Zealand to worry about the same matter? Both countries are heavily dependent on borrowing from foreigners to finance their economic activities but how do they differ? This essay will discuss the rationale of borrowing, the impact on the recent credit crisis, the ability to repay, the banking sectors and the impact of recovery packages.
We know that New Zealand is a country that borrows because the Current Account Balance (CAB) is less than zero; which is a current account deficit (i.e CAB<0). This also means that, with a current account deficit, the total of net export (NX) and net inflow of income (NFI) is negative. (i.e NX+NFI<0). The result of this is; national disposable income will be less than domestic spending. If this is the case, then savings must be lower than investment. Therefore, because the country is saving less, it must be getting some of its investment from abroad. Thus explaining why New Zealand borrows; it borrows for investing. US imports more than they export i.e, net export is negative, mainly because their exchange rate is higher than the countries that they heavily import from, which means it is generally cheaper to import. US’s net foreign income is zero compared to New Zealand, which is negative. This is mostly due to the interest payments on foreign debts. New Zealand’s friendlier tax laws and safer economy also causes more foreigners to invest here. The savings for both countries are different. New Zealanders consumes about 58% of their income but US citizens consumes even more; with 75% of their income being consumed (Bandyopadhyay, 2009). This means that US has less money going into their savings. US’s government spending is more than the amount of tax they collect, which is opposite of New Zealand. This causes US to borrow to pay for their expenditures.
The recent global financial contraction has caused a lack of credit in the market. The credit market is important in paying for household consumption, productions expenditures and investments, marketing and with import and exports. The lack of credit causes a drop in output, which results in a drop in sales, which then causes job losses, further reducing the loanable fund available and thus causing a lack of credit available to the market. This is a vicious cycle of decay which may cause a depression if it persists (Bandyopadhyay, 2009). During a credit crunch, the supply of loanable fund in the market is low, where New Zealand doesn’t have enough to take a loan from. Foreign investment also fall as investors are not able to get credit to fund their activites.
US government has collected a large amount of debt. If it is not able to pay them back in time, their credit rating will go down, thus making it harder to borrow in the future. They may even face a higher interest rate as a result of the lack of confidence in the US government. The decision that US government makes will affect the investment and export of New Zealand products to US. We will discuss 3 ways how the government can pay off their debt; additional private saving, additional public saving and inflation. Government will have additional private saving by encouraging individuals to consume less, save more and for businesses to grow; which will increase disposable income. To have additional public saving, government can put higher taxes or lower government spending. Inflation may be use to devalue the dollar, which makes the exchange rate lower, so to discourage import and increase export.
There is a vast difference in the banking and financial sectors of the US and New Zealand. Firstly, the US, over time, has slowly deregulated their banking and financial sectors, making it easier to lend out money. New Zealand is contradictory to that; it has a prudential supervision from the Reserve Bank of New Zealand. It constantly measures the bank’s capital and its risk weighted credit exposures, by using the capital adequacy ratio. The reserve bank also uses official cash rate (OCR) to influence the price of borrowing money. Just before the credit crisis hit the US, the OCR in New Zealand is high; about 8.25% (Reserve Bank of New Zealand, 2009). As a result of this, people spend less on goods and services because their savings are getting a higher interest rate. Conversely, people with mortgages and other loans experience higher interest rate, which means that people with a better credit rating are only able to borrow money. US is innovative in the sense that they have a mortgage based securities and insurance of financial products. As we have seen back in 2008, the mortgage based securities are collapsing; following the fall of Fannie Mae and Freddie Mac, which are issuers of these securities (Economist, 2008). New Zealand has legal restrictions against mortgage based securities, thus reducing our risk to such products. In US, as a result of these deregulations and financial products, banks are issuing subprime loans. When people start to default on their loan (which are mostly based by their property, mainly their house), banks start to foreclose on these properties. When the banks are trying to recuperate their losses by selling the property, it causes an oversupply, thus making the house prices to fall, by up to 30% in some areas. As more and more foreclosures and bankruptcies occur, banks start make losses and have trouble keeping their books healthy. In the financial sector, the collapse of security prices caused the insurance of financial products to fail. The discovery of frauds also adds to the lack of confidence that people are now facing (Janet Morrissey, 2008). Eventually, confidence is so low that banks stop lending, thus causing a credit crunch. New Zealand’s regulations restricted issuing of subprime loan, thus not resulting in a credit crunch.
Government are now trying to get out of this crisis by giving recovery packages to the economy. There are 2 major packages; monetary policies and fiscal stimulus. Monetary policies are used to reduce the OCR to boost investment. Lowering the reserve rate will also pump more credit to the market and will help firm carry out production (Mankiw, 2004). Government can bail out banks and financial institution by buying low quality assets thus preventing bankruptcies and foreclosures. International coordination (e.g, G20 meetings) of interest rate and exchange rates also boost the flow of credit between countries. Fiscal stimulus is ways to pump money back into the economy. One of the ways is to reduce tax and run the government on a deficit, thus providing more money for them to spend and save. Government can bail out troubled firms by giving subsidy and by buying shares. Finally, government can invest in health, education, energy and infrastructure. In the long run, a fiscal stimulus on health, education, energy and infrastructure will foster sustained economic growth. We shall discuss this with an aid of a graph.
The economy is now at point A, which is the current equilibrium point. Monetary policies and fiscal stimulus will cause the long run average supply (LRAS) curve to shift to the right, increasing the natural rate of output. The shift in LRAS will cause increase the aggregate demand (AD) curve, shifting it to the right. Firms will follow the lead of this demand shift and increase supply, thus shifting the short run average supply (SRAS) curve to the right. This will cause the equilibrium point to shift from A to B, thus increasing price level, causing inflation. If at any point in time, the economy did not react to the monetary policies and fiscal stimulus, the LRAS curve will shift to the left; back to its original position before the recovery packages are introduced. Firms will react to this cutting back production or shutting down, causing the SRAS curve to shift to the left. The equilibrium point will then shift from B to C, causing hyperinflation. A hyperinflation will cause capital flight, causing a sudden drop in the value of currency, which may start a currency crisis.
In the essay, we can discuss and conclude that New Zealand borrows to invest as compared to US, which borrows to consume. We noted that a decrease in loanable fund will cause a cycle of decay which in turn, leads to the credit crunch. We have discussed how Policy-makers are using monetary tools to affect the ability to pay off the debts. The differences of the banking and financial sector of the two countries has shown us that New Zealand’s restrictions has prevented a credit crisis. Recovery packages; both monetary policies and fiscal stimulus will help the economy back on track. Is there a similar cause for concern as the US, I say no. However, other concerns may arise as to whether or not the recovery packages will boost confidence, if not; we might be seeing an increase in barter economy.
Word count: 1499 words
Reference
Bandyopadhyay, D. (2009, May). A Crisis of Confidence in the Monetary and Financial System and the Prospect of a Great Depression. Unpublished lecture notes, University of Auckland, New Zealand.
Economist (Jul 17th 2008). Fannie Mae and Freddie Mac: End of illusions. Retrieved May 26, 2009, from http://www.economist.com/finance/displaystory.cfm?story_id=11751139
Janet Morrissey (Monday, Mar. 17, 2008). Credit Default Swaps: The Next Crisis?. Retrieved May 26, 2009, from http://www.time.com/time/business/article/0,8599,1723152,00.html
Mankiw.N.G (2004). Brief Principles of Macroeconomics (Third Edition). United States of America: Thomson South-western
Reserve Bank of New Zealand (2009). What is the official cash rate?. Retrieved May 25, 2009, from http://www.rbnz.govt.nz/monpol/about/0072140.html
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