In mid-1986, Finance Minister Douglas initiated the process leading to the RBNZ Act when he invited RBNZ and Treasury officials "to explore options for reforming the institutional structure o f monetary policy, with a view to reducing the scope for active political involvement in monetary policy decision making (Reddell 1999, p.65). As Governor Brash explains: "[There] was a perception that the previous National Party Government led by Sir Robert Muldoon had manipulated monetary policy in a very cynical way for the political benefit of that Government. So one o f the requests made to the Reserve Bank and the Treasury by the Finance Minister o f the incoming Labour Government was to find ways of ‘Muldoon-proofing monetary policy’, so that never again could government manipulate monetary policy for political gain."15 Douglas had in mind the type o f independence that existed at the Bundesbank or the Fed, which were the policy models that New Zealand wished to emulate. By mid-1988, all the significant institutional issues had been resolved and Douglas announced his intention to introduce the legislation, which was announced in the 1988 budget.
A key concern of Douglas's economic team was to lift confidence in New Zealand's economy and its currency by convincing the public that low inflation was going to be the norm. As former Associate Finance Minister Prebble recalls: "New Zealand had suffered double digit inflation under Sir Robert Muldoon's National government. MPs like myself studied inflation. I became convinced that inflation was bad for the workers - wages were always to catch up with inflation and never did. Inflation transferred wealth, particularly to property holders. Inflation undermined investment in
employment industries. 16 One reason for the RBNZ Act 1989 was to change this mind set and to reduce inflationary expectations.
Finance Minister Douglas delegated this process to then Associate Finance Minister Peter Neilson, who supervised RBNZ and Treasury officials in this process.17 Interestingly, the 'autonomy project1 was run on parallel, but distinct, tracks from the development of the inflation target.18 Neilson's main role was adjudicating between the Treasury and the RBNZ, as each organisation came up with competing frameworks that were fundamentally incompatible. The RBNZ was very focused on a "independent central banking" model while the Treasury focussed on an "accountable public sector agency" model.19 The different academic influences and policy experiences o f the two organisations explain these contrasting approaches taken, as seen below. The framework finally agreed represented a compromise between the two positions, combining the Treasury's principal-agent model with the RBNZ's independence with an inflation target.
Design of Central Bank Reform
The actual drafting o f the RBNZ bill was completed by the RBNZ itself, under a team led by Assistant Governor Peter Nicholl along with two RBNZ officials, Steven Dawe and Arthur Grimes. This team prepared all the policy documents, drafted the legislation, and wrote the accompanying Cabinet papers and ministerial speeches. In the words o f Dawe, they were responsible for "putting the economic theory/jargon into legal jargon". This work took place at the same time as wider public sector reforms, which led to the
16 The Hon. Richard Prebble, former Associate Minister of Finance , correspondence dated 2 August 2001.
17 Neilson had been a professional economist in the Department of Labour before going into Parliament in 1981.
18 Reddell (1999) provides a comprehensive discussion of the development of the inflation target.
19 Material in this section is drawn from discussions with present and former RBNZ and Treasury officials as well as their external advisers.
State Sector Act and Public Finance Act. Grimes admits that the RBNZ officials were largely ignorant of the specifics o f these other reforms but were aware o f the general thrust. The RBNZ team therefore recognised the need to establish a framework with clear objectives, clear monitoring and clear accountability structures. But the RBNZ team did not set out to consciously 'mimic' the other public finance reforms. Instead the primary focus was on making the RBNZ independent, a view was shared by Douglas.
A Treasury team, led by Howard Fancy o f the macroeconomic policy area, held intense debates with the RBNZ team throughout 1986 and 1987. A second key participant was Paul Atkinson, an OECD official who was seconded as manager o f the Treasury’s macroeconomic policy over this period. Due to the Treasury's position as chief architect o f on-going state sector reforms, Treasury officials were much more cognisant o f the need to fit RBNZ reform into this wider context. Treasury officials were preoccupied with the idea o f trying to find an output-based measure by which they could assess RBNZ performance to ensure accountability. The Treasury considered it inappropriate that the RBNZ target inflation directly, as this target was an "outcome" not an "output" for which the RBNZ could be directly accountable. The Treasury's focus on output measures led to a flirtation with monetary base control, as well as a suggestion to divide the RBNZ into two departments - an Issue department and a Banking department - so that note issue could be used as an output target.
Intellectual Influences on th e Design
Even today, RBNZ officials disagree on the primary influences on the institutional design o f the RBNZ Act 1989. One view points to the influence o f the economics literature on time inconsistency while another view looks to the principal-agent literature. The impact o f the former can be seen in the wish to have an independent
central bank, as protection against inflation-prone politicians, whereas principal- agent theory points to the contracting model wherein the Governor is held personally responsible for results. The time inconsistency view was introduced by Grimes, who had returned to the RBNZ in 1987 having completed a PhD in monetary theory at the London School o f Economics.20 Grimes was deputy head of the Economics Department, and worked on the details of the RBNZ Act 1989 over the next three years. In early 1987, Grimes drafted a seven-page memorandum summarising the key findings from the time inconsistency literature that was debated within the RBNZ. The memo outlined the work of Kydland and Prescott (1979), Calvo (1979), Barro and Gordon (1983), Backus and Driffill (1985) and Barro (1986) and provided some worked examples of time inconsistent policies. The memo featured a long discussion of the importance developing a reputation for credibility in a repeated game. Empirical support for time inconsistency was evident in the failure of inflation expectations in New Zealand to come down. In New Zealand, year-ahead inflation expectations were 14.1 per cent and 10 per cent, respectively, in March 1987 and March 1988, while actual inflation in these periods turned out to be 7.4 per cent and 4.1 per cent, respectively (Grimes 1996, p.256).
Missing from Grimes's memo is any discussion o f central bank independence as an alternative to reputation. While the empirical work supporting central bank independence was not widely developed in the economics literature at this point, practitioners were very familiar with the concepts and studied the existing institutional models. Governor Brash notes: "Prior to the drafting o f the RBNZ legislation in 1989, there was considerable work done by Reserve Bank staff on the various options for
20 At the LSE, Grimes was most influenced by Charles Goodhart, Mervyn King (now Deputy Governor of the Bank of England), and David Webb. Source: Prof. Arthur Grimes, Victoria University of Wellington, correspondence dated 31 July 2001.
independence, and these staff had contact with a number of people both inside New Zealand and abroad. As you will be aware, the model of central bank independence which was typical at that time was the Bundesbank model, also exemplified by the Swiss National Bank and the Federal Reserve, where the central bank has both instrument independence and a substantial measure o f goal independence". These central banks provided a number of features that were emulated in the design o f the
RBNZ Act 1989.
Grimes recalls that the idea to have a legally independent RBNZ with a single objective of price stability came up in discussion with the RBNZ economics group, following an internal seminar on time inconsistency. The officials present had been debating how it was not credible for one institution to be responsible for two policy objectives, such as inflation and employment. Instead the suggestion was made to have a single institution with one policy instrument pursue a single objective. This solution led to the institutional design based on an inflation target, similar to the statutory single targets at the independent Bundesbank and Swiss National Bank. What was novel about this solution was to link accountability formally to a specific numerical inflation target. When presented with this idea, Treasury officials objected to the inflation target as it was not strictly an output. Discussions between the two organisations delayed the drafting o f the RBNZ bill by a year while the two groups fought out their differences.
Visiting academics and central bankers also influenced the RBNZ's thinking. However, external economic advisers did not play a role in determining the fundamental institutional design. The RBNZ brought in one economic adviser to act as a 'sounding board', Professor Charles Goodhart o f the LSE. Goodhart was invited to New Zealand in 1987 and asked to comment on the RBNZ's blueprint o f the policy framework, although
he was not involved in the specific drafting.21 Goodhart was asked to critique the RBNZ's proposals internally before they were debated externally with the Treasury.22 The RBNZ arranged for Professor Goodhart to return in 1989 while the bill was before parliament to act as an "expert witness" in the Committee hearings on the legislation. At the Treasury, Atkinson arranged to bring in an external adviser, Professor Geoffrey Wood of City University Business School, who provided advice on monetarist issues.
Domestically, the RBNZ team ran their proposals past Roderick Deane, a former RBNZ Deputy Governor who left this position to become Head o f the Public Service in 1986 (among other positions), and Professor Frank Holmes o f Victoria University, who had worked as the Head of the New Zealand Planning Council. Otherwise domestic academics had no constructive influence on the RBNZ design. In fact, the RBNZ bill was opposed by “nearly all New Zealand university academics, economists and political scientists alike” (Caesar 2000). Keynesian-oriented economists and political scientists such as Dalziel, Easton, Kelsey and Whitwell were vocal critics o f the RBNZ's monetary policies over this period, and were opposed to the bill when it was debated before parliament (Dalziel 1989; Easton 1989; Kelsey 1996; Whitwell 1990). Professor Dalziel comments: "It was academic economists (including myself) who were loudest in pointing out the dangers o f independence... In official submissions to the hearings on the Reserve Bank Bill, the Reserve Bank was very critical o f academic economists for this reason".23
21 Charles Goodhart had a longstanding relationship with the Bank, having been the guest public lecturer at the RBNZ's 50th anniversary celebrations in 1984.
22 One idea that Goodhart originated, that was subsequently rejected as politically infeasible, was the proposal of tying the Governor's salary to the inflation performance. Walsh (1995) later picked up this idea.
Political Influences on the RBNZ Act 1989
Far from leaving all the detail to civil servants, politicians played a key role in three aspects o f the institutional design. Finance Minister Douglas provided the initial impetus for RBNZ independence. While Douglas may not have read the time inconsistency or principal-agent literature, these ideas were at the heart o f his own thinking. For his part, Associate Finance Minister Neilson played a very active role in shaping the final institutional design. Neilson was responsible for deciding that the Policy Targets Agreement would be expressed in terms o f an inflation objective, as opposed to the Treasury's recommendation to use an 'output' measure and the RBNZ's preference for no structure at all. And Neilson - together with Douglas - decided on the single decision maker structure to ensure greater accountability, siding with the Treasury perspective that it was possible to 'sack' one person, but hard to sack a whole Board. Finally the Treasury played a major role in determining the accountability framework that was adopted. The Treasury was able to impose restrictive funding provisions, whereby the Governor must negotiate the central bank's operating budget, albeit on a five-yearly basis, with the Minister of Finance.
Political D ebate over the Bill
The NZLP’s intention to give the RBNZ independence was first announced by Finance Minister Douglas in the 1988 Budget Statement, with the legislation to enact this reform being introduced into Parliament in May 1989 and becoming effective in February 1990. By December 1988 Douglas had left the Cabinet, leaving newly-appointed Finance Minister Caygill to steer the legislation through the House. The Act was controversial, particularly the adoption o f an inflation target o f 0 to 2 per cent when unemployment was approaching double digits. In his introduction o f the RBNZ bill (later the RBNZ Act 1989), Finance Minister Caygill set out the objectives for these reforms:
The Bill is significant. It implements a reform that was announced in the 1988 Budget. It will place the Reserve Bank on a more independent basis to improve the credibility, consistency, and effectiveness of monetary policy. The Bill is an important ingredient in the Government's battle to get inflation down and to keep it down... The Bill places the bank on a more independent, but also more accountable, legislative basis than at present, while recognising that it is the Government's right to determine economic policy. Within that constitutional framework the Bill sets the primary objective for the Reserve Bank's implementation o f monetary policy as the achievement and maintenance o f price stability. It also provides for the Government by Order in Council to substitute alternative economic objectives.24
After the first reading, the bill was sent to the House o f Representatives Finance and Expenditure Committee (“the Committee”) for review. The Committee considered 25 submissions and 9 supplementary submissions, and heard 12 hours o f evidence from 19 witnesses.25 Officials from the Reserve Bank provided the Committee with 23 reports on the Bill which the Committee spent a week considering.
Submissions to the Committee revealed disagreement on two main issues: the narrowing the RBNZ’s statutory objective to the pursuit of price stability, and the reduction of the RBNZ’s supervisory role to cover only registered banks.26 The Reserve Bank, the New Zealand Treasury, the Federated Farmers and the New Zealand Business Roundtable firmly supported the concepts in the bill. A number o f groups opposed legislating a single objective of price stability: the New Zealand Council o f Trade Unions ("NZCTU"), the Manufacturers' Federation, the Public Service Association, the National Council o f Women and a large group o f New Zealand academics. The NZCTU
24 Hansards, 4 May 1989, “RBNZ Bill - Introduction”, Speaker: Hon. David Caygill. 25 Hansards, 12 December 1989, “Report of Committee”, Speaker: Mr. J.R. Sutton. 26 Hansards, 12 December 1989, “Report of Committee”, Speaker: Mr. J.R. Sutton.
called the focus on price stability “a misguided and dangerous initiative” (Kelsey 1996, p. 163). Professor Dalziel highlighted the risk of hysteresis o f unemployment resulting from an anti-inflation policy, and argued for recognition o f the need to coordinate monetary and income policies in the bill (Kelsey 1996, p. 162). Opponents to the bill argued to keep the status quo with the RBNZ pursuing multiple objectives including employment and output growth. A number of witnesses also questioned the wisdom of limiting prudential supervision to registered banks.
In December 1989 the Committee returned the bill to Parliament substantially unchanged. Opposition Finance spokesperson Ruth Richardson (later Finance Minister) convinced the National Party to support the Labour Government's legislation, despite the continued opposition o f Sir Robert Muldoon who called it a 'foolish piece of legislation' (McLeay 1991, p.87). In December 1989, the RBNZ Act 1989 was passed by Parliament with the support of government and opposition, without a single vote being
27
registered against it (Brash 1996b).
The degree o f political consensus surrounding the RBNZ Act was evident during the October 1990 election as none of the political parties made any mention o f the RBNZ Act 1989. The National Party won with a large majority, capturing 69% o f the seats in Parliament - the biggest electoral majority since 1935. As promised, bi-partisan support for the RBNZ Act 1989 continued, although the Policy Target Agreement was renegotiated with Governor Brash to extend the time horizon for achieving price stability to December 1993. Finance Minister Richardson continued the reforms, pushing through the Fiscal Responsibility Act 1994 that laid out the principles o f sound government finances. She also introduced long-awaited labour market reform. Both
reforms were designed to support monetary policy by giving it ‘some friends’ in the fight against inflation.
Econom ic P erform ance Following RBNZ Act 1989
The reforms introduced by the RBNZ Act 1989 had greater economic success, but at the cost o f a disinflation and painful adjustment in early 1990s. Inflation fell faster than anyone expected, reaching 2.1 per cent by September 1991 then remained between 0 and 2 percent until June 1995. Inflationary expectations were also sharply reduced as seen in long-term bond yields in New Zealand, which were consistently lower than comparable rates in Australia and the UK. After peaking at 10.9 per cent in September 1991, unemployment fell to 6.2 percent in 1996. From 1993 the economy began to recover strongly with GDP rising by 5.6 percent in 1993 and 6.2 percent in 1994 - the fastest growth rates in the OECD during this two-year period (Brash 1996b). The fiscal deficit, which reached nearly 7 percent of GDP in budget year 1983/84, was gradually reduced so that by the 1989/90 budget it was down to just 1.3 percent o f GDP. Net government debt fell from a peak o f 52 percent o f GDP in 1992 to around 33 percent in
1996.