NZ 'on a death spiral' says US economist

By NZPA

Thursday 19th July 2007

The New Zealand economy is on a death spiral by having a free, floating exchange rate combined with inflation targeting, according to a leading US economist.

Steve Hanke, fellow of the Cato Institute and professor at Baltimore's John Hopkins University, said New Zealand should abandon its free-floating exchange rate and peg it to a key larger currency such as the US dollar, or a basket of currencies.

His comments come as the New Zealand dollar continues to soar towards US80c, a record since it was floated 22 years ago. It has risen 27% this year alone, crippling many exporters.

Finance Minister Michael Cullen cause a storm when he hinted yesterday he could use emergency powers to suspend the Reserve Bank's sole focus on inflation.

Most economists expect the Reserve Bank to put further upward pressure on the exchange rate next week by hiking interest rates for the fifth time this year and economists from at least two leading banks said a sixth hike is probable in August.

Hanke, an adviser to the late former president Ronald Reagan, told Radio New Zealand today the currency cannot be allowed to continue its violent fluctuations.

The current framework left New Zealand "like a dog chasing its tail".

To fight inflation the Reserve Bank hiked interest rates, but because New Zealand had higher interest rates than other developed countries because it is a small economy, that attracted a flood of capital from offshore where rates are lower, which pushed up the exchange rate.

He said that aggravated the inflation problem and the central bank then had to increase rates again and start the whole cycle again.

"In a way it's a kind of death spiral you're in."

Hanke said it was inappropriate in a small, open economy to have a system of inflation targeting and a free, floating exchange rate.

"It's obvious to everyone that this isn't the paradise that everyone thought it was."

He said the opposition National Party's suggestion that the problem could be fixed or alleviated by cutting spending was politically unrealistic.

Another "fix" to impose capital controls such as reserve asset ratios on banks was a poor alternative, he said.

What could save the day, he said, was a system modelled on Hong Kong's where the New Zealand dollar would be pegged to the US dollar. Just as easily, New Zealand could fix its currency against a basket of currencies.

The exchange rate would be fixed but freely convertible and fully backed by foreign reserves.

"That is the only way out -- that will keep the economy open, free. There will be a free market mechanism that will get rid of the violent swings in the exchange rate that cause no end of trouble."

Hanke doubted there was the political will to change New Zealand's monetary policy and exchange rate system. There was likely to be a long, drawn-out debate before any change.

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