New Zealand To Propose Fiscal Austerity To Reduce Trade Deficit?

A reader asked me to comment on this article in the New Zealand Herald. Some economists at the Treasury in New Zealand argues that if New Zealand would tighten fiscal policy this would lower interest rates, something which in turn would weaken the exchange rate something which in turn would reduce the trade deficit in New Zealand.

They are right insofar that fiscal austerity will indeed reduce interest rates and also reduce the trade deficit in New Zealand. The reduction in the trade deficit will be lower than the reduction in the budget deficit (it is not so to speak any "identical twin deficit relationship"), but it will clearly reduce the trade deficit.

That reduction will because of New Zealand's floating exchange rate system in part be the result of the lower exchange rate of the New Zealand dollar caused by lower interest rates. "Autonomous" shifts in interest rates will have a more ambigous effect on the trade deficit, but a reduction caused by higher government savings will unambigously reduce the deficit.

However, while their theoretical predictions are basically correct, the terms used indicate that they probably exaggerate the net value of these effects for New Zealand.

The reader indicated that he wanted to know the investment implications of this. Well, such a move will likely reduce real interest rates something which as I explained in the previous post makes investments in New Zealand dollar denominated securities somewhat less attractive. However, New Zealand has had higher interest rates before even during times of budget surpluses and they will likely continue to have structurally higher real interest rates, even if the proposed strategy is implemented.