The Rankin File: #14

The tenth anniversary of the sharemarket crash of 1987 is being featured in our media. 1987 is set to become an icon; a defining year in New Zealand's folklore. It will join 1642, 1769, 1840, 1893, 1915, 1935, 1953, 1981 and 1984. It will probably become better known than 1960 or 1995, the years of New Zealand's greatest successes in sport.

Interestingly, 1987 is only being canonised as a defining year in New Zealand. In other countries, it was no more than a sidelight in their financial histories. This is because the crash was a very different event here, because of its much greater extent here, because of the unprecedented culture shift following from that other defining year, 1984, and because the political response ensured that, in New Zealand unlike other countries, the financial crisis would be followed by an economic depression.

In New Zealand in 1997 equities are valued on average at 60% of their inflated 1987 values. In the USA, shares are now valued at double the pre­crash level, about triple their post­crash lows.

1987­92 was a depression of the classical form; but it was a national depression rather than an international depression as occurred in 1929­33. Quite unlike 1930 and 1931, the years 1988 and 1989 were boom years in the international economy. Indeed the international sharemarket "correction" actually triggered a boom in the leading capitalist economies, in two different ways.

With the exception of New Zealand, the world's central banks opened up their vaults in October 1987. They accommodated the crisis by enabling the creation of as much money as was needed to ensure that the crisis would not spread from, Wall Street to USA Incorporated. Or from Threadneedle and Throgmorton Streets to the ordinary citizens of the United Kingdom, who were in no mood to go through 1980 and 1981 again. American historical memory of the early 1930s, unlike New Zealand's, was one of debilitating bank failures. Even Australia had its memory - etched in its folklore - of 1893 and the collapse of "Marvellous Melbourne". New Zealand had forgotten the BNZ debacle of 1894.

The crash boosted the US economy and the international economy in another important way. Internationally, in the years preceding the crash, investment capital was attracting itself to the financial sector and the merry­go­rounds like rabbits to RCD. Cities from Dublin to Vienna to Auckland fancied themselves as world financial capitals, and activities like agriculture and manufacturing were for regarded as somewhat Jurassic. The crash enabled capital to move back into the less fashionable manufacturing sectors of each national economy, generating higher growth rates in the USA, Australia, and the European Community. Japan, which hardly experienced the crash at all, continued to teeter under the weight of its overvalued financial assets.

On close examination there are some important parallels between the New Zealand depression of 1987­92 and the international depression of 1929­33. In the three lead­up years, agriculture was in deep trouble. Agricultural prices had been at historical lows. There had been accelerated rural to urban migration, farmers sought to live off their capital, and many eventually walked off their land. Indeed the year 1927 was one of significant emigration from New Zealand, and Australians emigrated in large numbers in 1928­30. An early New Zealand example of someone walking off his land in the late 1920s to make a new very different life for himself was Rewi Alley.

Another key parallel with respect to the financial sector was that there was plenty of warning for those with eyes to see it. The growth of prices in Wall Street was muted in the first three­quarters of 1929. The practice of banks lending money to buyers of shares had peaked in 1928, just as it did in New Zealand in 1986, not 1987. I knew in early 1986 that a big crash would come to New Zealand, when the financial press had started advertising share trading on margin. I had read J.K. Galbraith's book, The Great Crash.

New Zealand actually had two crashes in 1987. According to the popular Barclays Index, the sharemarket peak for 1997 was on January 3. The index number was a whisker below 4000. By the first week of May 1987, the Barclays Index had fallen to 3000. That was as big as most crashes get. Judge, Hawkins and Renouf were facing ruin early in 1987.

The worm turned in May 1987, while our eyes were turned to Sitivene Rabuka and the various carryings on in Fiji. Roger Douglas decided to inject a bit of heroin into the New Zealand economy. His backers were in trouble, and the polls had showed that the Labour government was also in deep trouble. An election had to be called by September at the latest.

The more visible part of Douglas's political rabbit­out­of­the­hat trick was the budget surplus announced with much fanfare and Treasury gloating in the first week of June 1987. This surplus was made possible by the higher taxes in turn made possible by the high growth rates and high tax rates inherited from the Muldoon Government, and by high inflation rates in 1985 and 1986 pushing the additional wages paid in 1986 (after the 1985 wage round) into the high tax zone. The high inflation in 1985 had had little to do with the aftermath of the Muldoon price freeze. It was linked to the 20% devaluation in 1984 which should really have been a 5% devaluation. (Muldoon, while he may have precipitated a political crisis after the election, was correct in his economic analysis.) Double­digit inflation was not a part of even Treasury's forecasts as late as November 1984.

The Douglas­Lange Government in its first term had been a spendthrift government, whereas the Muldoon Government had been far from that. Labour had been politically lucky, in that government revenue had risen even faster than government spending.

Political luck with respect to the public accounts was only a part of the story of Douglas in 1987. The real action was in monetary policy. Since the financial reforms of 1985, it became possible to simultaneously deflate and inflate the economy. Since the 1989 Reserve Bank Act this is less easy to do than it was in 1987, because of the division of powers between the Reserve Bank Governor and the Minister of Finance. Following MMP there is now an effective three-way division of powers with the introduction of a new position, the Treasurer. Almost always, the Treasurer and Minister of Finance will be from different political parties.

In 1987, monetary policy tightened sharply. Interest rates shot up to levels only seen before in 1985. The exchange rate soared into the financial stratosphere. Manufacturers really started to feel the pain. Surviving farmers were less badly hit. International prices of their products began to rise - a lucky coincidence for them and for the Government - and they could always raise their incomes by depleting their breeding livestock.

Money supply growth reignited. Foreign "hot money" poured in as it had done in 1985. Banks lent virtually whatever they were asked for, to just about anyone except farmers and manufacturers. The New Zealand economy in mid-1987 became locked into a capital gain mentality. Short-term returns vastly in excess of the 20­30% interest rates opened the monetary floodgates. By election date, the New Zealand economy was swimming in a sea of liquidity, made possible ironically by the raising of domestic interest rates.

In 1987, house prices in Wellington and Auckland rose high enough for ordinary families to sell their highly mortgaged homes for a huge capital gain, and buy a good house mortgage­free in Queensland. House prices in Wellington and Auckland were further boosted by the huge mortgage subsidies paid to the bloated workforce in the finance, business and government services sectors. At the same time, house prices in Hastings, Wanganui and Timaru were falling.

The party had to come to an end. You cannot have a high interest rate high exchange rate policy without eventual grief. The dramatic but manageable financial crisis of early 1987 had been overlaid - thanks to our naive illusions at the time, and, since, to popular memory - by the events from May to December 1987; events that could have come straight out of Alice and Wonderland.

1988 was simply the necessary unravelling of the destructive political manipulation of the financial markets in an election year; a year which, given the consequences of the January 1987 crash, would have otherwise seen the demise of the Fourth Labour Government.

We haven't learned the lessen. While the Reserve Bank Act reduced the constitutional power of the Minister of Finance, the ideological basis of that legislation, combined with that of the 1994 Fiscal Responsibility Act, means that there is now a strong inbuilt bias towards policies that are deflationary if pursued in a large dominant country like the USA (the country from which most of our economic textbooks are sourced).

But we now know from 1985­88 that in a small open economy, these policies work through a "hysteresis" effect. The medium­long term deflationary consequences of high interest rates and rising exchange rates may take 3­5 years to predominate over the short­run inflationary boost to the financial sector. In 1994 there were monetary policy parallels with 1985. Interest rates were pushed up, and, by aggravating inflation rather than curing it, monetary policy stayed tight for three years. The result was an environment in 1996 like a muted version of 1987: farmers and manufacturers in deep trouble, huge annual increases in the money supply, renewed capital gains in particular in the Auckland property market.

1996, like 1987, was an election year. Messrs Bolger and Birch didn't have to do much other than to exploit the environment set for them in 1994 by Dr Brash and by Ruth Richardson, who sponsored the Fiscal Responsibility Act as her political swansong. With masses of money sloshing around in the New Zealand economy in 1996, employment was up, and New Zealanders were able to spend once again. The election result was a substantial shift to the political right.

The legacy of the "year of the crash" is that New Zealand in 1997 is a much more unequal society that it was in 1987. The yuppies, taken collectively rather than individually, have proved to be the big winners (see "Prices and Wages: 1987-1997"), even if they are less "in your face" in their display of wealth. The legacy is not that of the crash. It is the legacy of a policy environment that created both the crash and its depression aftermath; of a policy environment that made the post-crash legislative milestones possible.

Economic policy remains locked into the thought patterns of the 1980s. And hysteresis still rules. Events today that are a result of legislative and monetary policy decisions made in 1991 and 1994 have created a sense of frustration in 1997; a frustration falsely attributed to MMP and NZ First, just as the New Zealand economic crash of 1988 was attributed to an international sharemarket crash, and as the world economic crash of 1930­31 was falsely attributed to the Wall Street crash of 1929 and to international Jewish conspiracies.

Depressions typically happen when the political response to a financial crisis is to aggravate the problem or problems that caused the crisis. Inevitably it is the acute financial crisis, as the most prominent leading symptom of the real crisis, that enters the popular memory.

AFTERWORD: In order to avoid the intensity of the political cycle in New Zealand - the cycle that led to quite inappropriate monetary conditions in 1987 and 1996 - I would like to see (eventually) the following reform to MMP. The country could be divided into four regions (North, Central, South and Maori). Each region would have its own MMP election every four years. And there would be an election in, say, August every year (eg each region would have its election in a different year.) This would provide more political continuity, as well as regular and more frequent accountability.

{Note: My comments were used in the Herald's "Age of Excess" feature (11 October), in particular the part headed "Crazy, hazy, greedy days of the 80s". This is my email communication to the Herald.}

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