Like its OECD counterparts, New Zealand’s economy has been badly affected by the international economic crisis, but it also suffers from long standing domestic imbalances that were accentuated by the earlier period of excessive global liquidity and low risk aversion. In the early stages of the crisis, New Zealand seemed well positioned to escape its worst effects. Its banks had almost no exposure to sub-prime mortgages or other “toxic assets”. When the recession began in early 2008 it could be attributed to domestic monetary tightening, the early stages of an overdue housing market correction and temporary drought conditions. As international turmoil intensified, however, it became clear that New Zealand would not escape a deeper recession, and in early 2009 macroeconomic indicators deteriorated significantly. New Zealanders had in fact been caught in much the same spiral of global excess liquidity, surging leverage, soaring asset prices and under-valuation of risks by lenders and borrowers that had taken hold globally. Households’ indebtedness reached 160% of disposable income – and, in aggregate they cut their saving, possibly in the mistaken expectation that ever appreciating house prices would fulfil their future savings needs, notably for retirement. As already meagre personal saving fell further, and business borrowing increased strongly, even healthy corporate profits and steady government surpluses were insufficient to finance booming private consumption and housing investment. Hence, much of the financing came from abroad. The results were excess demand pressures, a widening in already unsustainable current account deficits and rising net foreign indebtedness (93% of GDP at end-2008).

Even though New Zealand’s banks are sound, global interdependencies and accumulated domestic imbalances mean that the economy is being affected by the worldwide financial and economic crisis. New Zealand has one of the OECD’s highest levels of foreign debt, the result of sustained and sometimes large current account deficits that reflect a long period of unbalanced growth and structural deficiencies, notably a small pool of household savings and a low rate of productivity growth. These imbalances, along with the present reversals in global risk appetite and credit availability, present a risk of sudden and costly macroeconomic adjustments. As a small nation on the world’s periphery, New Zealand is affected by the sharp decline in world trade, which began in late 2008 and is unlikely to be reversed during 2009. At the start of the crisis, both fiscal and monetary policies had substantial room for counter-cyclical action, and much has been done on both fronts. There remains more room for monetary policy easing than in most OECD countries, while fiscal policy is now constrained by the projected growth in debt and associated credit-rating concerns. Even so, a deep and protracted recession, involving a housing-market correction and deleveraging of household and business balance sheets, is unlikely to be avoided. As principal intermediaries between foreign savers and domestic borrowers, banks depend to a large extent on overseas funding, most of which is short term. A number of smaller finance companies, less regulated than banks, have gone bust. To maintain confidence in the banking and financial sector, new guarantee schemes for retail deposits and wholesale bank funding have been introduced, along with temporary liquidity facilities, and non-bank deposit-taking institutions have been brought under the central bank’s regulatory umbrella. The main challenges for policy makers are to manage the downside economic risks posed by the current crisis, while preserving the longer-run credibility of the macroeconomic policy framework.

New Zealand’s living standards remain well below the OECD average. This is entirely attributable to persistently low labour productivity, which in turn is related to economic geography as well as structural policy factors. The small size and remoteness of the economy diminish its access to world markets, the scale and efficiency of domestic businesses, the level of competition and proximity to the world’s technology frontier. This points to the need for a “New Zealand policy advantage”, that is, a set of structural policies attractive and welcoming enough to overcome the geographic handicap and attract the drivers of prosperity – investment, skills and ideas – to New Zealand. The reforms of the 1980s and 1990s laid much of the groundwork for creating this advantage and for a pickup in productivity growth. But in recent years, New Zealand has lost ground relative to its OECD peers. The reform focus has shifted away from growth and the government has introduced a large quantity of often poor-quality regulation. Policies should be refocused around the productivity goal in a number of areas, beginning with those covered in this chapter, namely international trade, the business climate for domestic and foreign investment, public-sector efficiency, infrastructure, innovation and natural-resources management. This chapter also evaluates the recently legislated emissions trading scheme through a productivity lens.