Here’s five reasons why Reserve Bank governor Alan Bollard should have held the Official Cash Rate at 5% this morning, rather than the 150-basis-point cut to 3.5% he delivered.

1. We have a savings problem.

The best way to encourage savings is to keep interest rates above 5% at least. A lot of people forget there’s about a million New Zealanders who have about $110 billion in bank accounts, term deposits and debentures. When the OCR is cut their incomes fall fast. About two-thirds of these savings are either on variable “call” rates or on terms of one year or less.

A lot of people also forget that we have a massive current account deficit problem. It has been stuck over 8% for four years. It reflects the fact that we spend more as a nation than we earn and we borrow the difference (or sell assets when we can). We have borrowed so much that now a large chunk of that deficit is the interest payments on previous borrowing. It is unsustainable and requires New Zealanders to save more. Cutting the price they receive for those savings is a mistake. Our domestic savings rate has actually improved over the last year, at least partly because interest rates were over 7% for a period.

All the media coverage around interest rate cuts is essentially celebratory and one-sided. The media (often populated by young borrowers) assumes everyone has a mortgage and that every business is an exporter (because they are bigger and scream louder than everyone else). Rate cuts and the inevitable fall in the exchange rate benefit borrowers and exporters. They hurt savers and importers. Rate cuts help the young and farmers. They hurt elderly investors on fixed incomes, retailers and consumers who buy a lot of imports, including, for example, Pharmac.

2. We have a spending problem.

New Zealand has a current account deficit problem that foreign investors are worried about. It is a result of us spending too much on imported consumer goods, overseas holidays and borrowing too much to buy leaky apartments and baches we live in for a couple of weeks every year.

Lowering interest rates encourages us to borrow and consume. It’s cheaper to buy more flat-screen televisions, iPods and those cute little Netbooks (I want one like crazy but would be lynched by my wife if I bought one home, even if I said I won it in a competition or was “writing up a review for Hewlett Packard”…hint hint).

3. We are on notice to pull up our socks.

Standard and Poor’s told us earlier this month that our AA+ sovereign credit rating was on notice for a potential downgrade because our current account deficit was too high and the government’s finances were deteriorating very fast. In recent years we avoided a downgrade because the government was running surpluses, offsetting the profligacy in the household sector. Now that we are heading aggressively into budget deficits our national savings rate is in deep trouble.

Cutting the Official Cash Rate sends the wrong message to international investors about our ability to defend our currency and about our resolve to increase our national savings rate. We are in a recession for a reason. We spent and borrowed too much. We now need to reduce spending and repay debt to reduce our indebtedness relative to our national income. That means accepting a lower standard of living for a while, spending less and borrowing more. There is no no magic wand. If you’re looking for a precedent, look at Iceland. We’re not nearly as bad, but if we lose the confidence of international investors in this febrile climate of fear and ruthlessness then we will be forced to lower our standard of living in a way we can’t control. Our currency would really collapse, interest rates would spike over 10% and unemployment would be over 10% in a flash.

The last time our savings rate slumped like it has over the last couple of years, which was in the late 1980s and early 1990s, our credit rating was cut two notches from AA+ to AA-. It was only upgraded again to AA+ in the mid-1990s after the government fixed its budget situation. Here’s our credit rating history.

4. It won’t make a difference
Rate cuts are a waste of time as a way to encourage consumers to spend or businesses to invest at the moment. Consumers are in debt reduction mode because they know in their hearts they have to pull their heads in. Interest rates have already been cut 325 basis points but the housing market is still falling and we just had a miserable Christmas.

The housing market has further to fall and everyone knows it. Being able to borrow cheaply is great, but if you still think a house is overvalued you won’t buy it. If you think you have enough debt already then a cut makes no difference.

Also, banks have tightened their lending criteria and increased the deposits required, which has a much bigger impact on how much can be borrowed. A borrower with a $40,000 deposit used to be able to borrow up to $760,000 to buy an $800,000 house when the limit was a 5% deposit. Now the bank is demanding a 20% deposit, the same home buyer with the same $40,000 deposit can only borrow $160,000 to buy a $200,000 house. This is the power of leverage that shocks people when you spell it out. This is why I am sticking with my forecast for a 30% fall in house prices.

Businesses are also unlikely to be racing out and investing in building new productive capacity when they know that virtually none of the OCR cut will be passed on and there will be little or no extra demand for the extra production anyway. Banks have passed on just 65 basis points of the 325 basis points of cuts in the OCR to business borrowers since the RBNZ started cutting in July. The average base lending rate for businesses was still 13.25% just before the rate cut this week, despite the OCR being reduced from 8.25% to 5% in the last six months. Banks are being very careful because, unfortunately, businesses are riskier than homeowners.

One of the great ironies of the last six months is that banks have passed on cuts in the OCR very quickly to savers by cutting term deposit rates and savers have had to accept this quickly because they roll over their deposits every six months or so. Meanwhile, the $180 billion of mortgages are mostly on one-to-two-year fixed terms and have not had the rate cuts passed on so fast because of that longer rollover period. The net result is that the easing of monetary policy has actually reduced the cash going into the economy in the short term at least.

5. We still have an inflation problem and there’s enough stimulus already

As recently as December 4, even Alan Bollard warned that domestic inflation was still a problem. Non-tradeables inflation, the stuff we can control, rose to 4.3% in the December quarter from the same quarter a year ago. Power companies are still putting up prices with impunity. Electricity prices rose 7.7% in the last year. Regional, city and district councils are putting up rates without too many second thoughts. Rates rose 6% in the last year. Prices of imported goods are also rising fast because of the slump in the New Zealand dollar. Refusing to cut the OCR might have grabbed their attention.

The other reason why the OCR should not have been cut to a historic low is that we already have an enormous amount of stimulus going into the economy. Most New Zealanders don’t realise that our government’s stimulus of 3% of GDP over 2007 to 2010 is actually the third biggest in the world behind Iceland (!) and Denmark. It was actually bigger than the US stimulus as at the end of December. The OCR cut from 8.25% to 5% inside six months is the biggest, fastest fall in the history of the OCR.

People are running around as if we are in a depression. Let’s not forget that unemployment is still only 4.2%. The last serious recession we had, in 1991, saw the jobless rate rise over 11%. The fall in the New Zealand dollar versus the US dollar is also very steep and large in the context of the last 25 years.

It makes no sense to be pumping so much stimulus into an economy that just a few months ago had labour shortages and an inflation rate over 5%.

Last 5 posts by Bernard Hickey

• Dear John: Please tell us the truth about the economy - we can handle it - February 23rd, 2009
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• Why we should give thanks when Telecom ‘exports’ 250 jobs to Manila - February 4th, 2009
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