The Goal of Increased Stock Market Investment - Is It a Recipe for Disaster?

By Lowell Manning27/1/08

"To suggest that the New Zealand economy depends on investment in the stock market is absurd and ignores the fact that most of the companies on the New Zealand stock market are overseas owned and therefore profits go overseas with little if any benefit to this country.
To have as a goal that all New Zealanders invest in the stock market I consider a recipe for disaster".
Ian Ritchie, Palmerston North 28/1/2008 in email to Radio NZ "ninetonoon".

Investors world wide have only 5 avenues of investment I can think of, unless you count war as an investment.

- bank deposits
- government or commercial paper
- "precious" metals, artwork and the like (an extension of hoarding cash under the mattress)
- property
- equities (shares)

Bank deposits are usually safe but passive and their yield relies upon active investors investing under one of the remaining four headings . So it is not strictly an independent investment sector. There is considerable trading in bonds, but the government is not in (net) significant borrowing mode and commercial paper usually relies upon an economy active enough to generate "growth". Buying precious metals, artwork and the like is an age old hedge against inflation, but very few people have the skills needed to use this category as an effective vehicle for investment.

Thus for ordinary people equities and property are the most practical options for active investment if they had anything to invest. And so if the government is trying to deflate the property market the only investment growth sector left is equities. Hence the "goal" of getting investors into the stock market.

It is true to say in a sense that the economy depends on investment in the stock market. If nobody invested there would be no companies on the stock market and thus no production from them. Of course if ordinary people invested in small businesses and cooperative enterprise rather than listed companies the economy might well be more sustainable and better equipped to face future challenges. So one powerful argument would be to set out to broaden the productive base of the economy through (government guaranteed?) investment in new enterprises and venture capital pools. However that is not going to happen over night.

However, it isn't true to suggest that the profits generated by New Zealand investment will go offshore. Dividends and share market growth are usually apportioned according to shareholding. Thus NZ investment in the NZ stock market would potentially dilute foreign ownership and could even return companies to NZ control. But in the first instance the profits through NZ investment would accrue to New Zealanders in New Zealand. Of course, if those receiving the dividends then chose to invest those dividends offshore, the purpose of promoting the investment in the first place would be largely lost.

The remaining and more substantive issue is whether stock market investment is a recipe for disaster. To answer that one needs to understand that the total debt has its counterpart in deposits somewhere, wherever they are invested. In New Zealand's case Domestic Credit (thus excluding the accumulated current account deficit or net overseas investment position which represents overseas debt) is around $270 billion. The bulk of those deposits represent the available investment pool, some of which is already invested offshore. The deposits reside in private and institutional investment accounts.

The deposit base grows by many billions of dollars each year mainly to fund interest charged on the total debt (that's both domestic and overseas debt), and provisions for inflation and growth. The unearned income (interest) component is by far the largest component in New Zealand because of the high interest rate regime here. It is, on its own, adding almost $30 billion of new credit to the system each year. Domestic Credit alone increased by around $26 billion last year. This means more money deposits to exchange much the same quantum of investments, and so the share and property markets must continue to inflate, other things being equal, because more money to buy the same amount means higher prices. So stock market investment is an utterly essential part of the present financial system. Even a tiny part of all those billions migrating to consumption would cause a monumental blowout in domestic inflation. That's how fragile our system really is.

There are only two ways to reduce total debt. It can be repaid, or it can be written off through default. Both mechanisms are at work during an economic slowdown. In the first case borrowers like households and homeowners use whatever they can spare to repay mortgage and other debt instead of spending it. By doing so, consumption is reduced and the economy falters. To a large extent, then, the effort to get people to invest in equities rather than repay debt is an effort to keep the economy going. A very blatant attempt to do just this is presently apparent in the US. Whether or not this is a disaster depends rather upon your point of view.

Essentially, the first thing that happens when credit is tightened and interest rates rise (we've already been through that stage) is that people have less money to spend from incomes after (higher) fixed costs like mortgage and interest payments are taken out. That causes consumption in the economy to stagnate or fall unless people can be enticed to keep spending as happened with the sub-prime mortgage scandals in the US. Eventually consumers becomes debt saturated and the 'belt" is tightened. But total debt keeps expanding as long as interest rates remain high and the current account remains heavily in the red. Consumers and homeowners are left struggling with little spare money to invest anywhere.

While consumption becomes constrained, unearned incomes (from high interest) may still be rising, leaving spare deposits in the hands of the investment sector. And as consumption is static or falling, business growth becomes severely limited. As a result, some at least of those spare deposits are likely to be used to retire existing debt instead of being recycled into inflating prices in the investment sector. Thus under current policy, the proposal about investing in the NZ stock market really boils down to a plea to the holders of investment deposits to keep up asset inflation instead of reducing debt. That's basically Greenspanesque jawboning, pure and simple.

Until interest rates fall or wages rise substantially, ordinary people have little to add to domestic demand. In that case further asset inflation means a lower return on investment in the productive sector eventually leading to capital flight on the one hand or business closures on the other. The investment plea is therefore likely to be counterproductive for the time being. What the economy needs is reduced interest rates and hence a lower dollar coupled with measures to quite drastically reduce the current account deficit over the medium term.

There is a silver bullet for this: a variable but tax neutral surcharge on the exchange of NZ currency to reduce imports, increase exports and lower the exchange rate while using the revenue from this to reduce domestic taxation. Imports will become dearer, and there will also be some inflationary pressure from increased export returns in the first year or so of implementation. However, the reduction in interest rates will significantly ease inflation in the investment sector as well as provide homeowners and households a substantial boost in spending power. The challenge will be for the productive sector to increase productivity thus drawing investment into the sharemarket as the government says it wants.

And that, I suggest, is the route that needs to be followed to achieve the investment goal. The proposal appears to be consistent with all international obligations as they all have saving provisions allowing serious current account imbalances to be managed. Many of the present global financial problems are the direct result of a shocking imbalance in current accounts the world over. They are what the famous economist John Maynard Keynes desperately sought to prevent when the post World War II international financial architecture was established; but his views were vetoed by the US who insisted on dominating the post war world by using the US dollar as the world's "reserve" currency.

There are, of course, several downstream technical effects from introducing an exchange surcharge of the kind I'm suggesting. Short term currency speculation would cease unless (by some misfortune) a separate lower surcharge rate were set for such financial flows. Removing currency speculation will help stabilise the New Zealand dollar but to ease the transition to stability, the surcharge may have to be introduced step by step to allow capital flows to adjust predictably.

My proposal may seem quite radical, but it is fully consistent with Keyne's proposals. It has to be seriously considered now, I suggest, because there may be no other permanent solution to New Zealand's dilemma: how do we get our interest rates down (as close to zero as possible) and productive investment up while managing inflation in both the productive and investment sectors?

To avoid the dramatic distortions between the productive sector and the investment sector that have destroyed many New Zealanders' hopes of owning their own home or investing in the stock market, inflation in the productive and investment sectors must both be similarly targeted. It is, I suggest, untenable to continue with double digit inflation in the investment sector while setting a 3% target for inflation in the productive economy. If inflation is to be capped around 3% in the productive economy it must also be capped around 3% in the investment sector. Otherwise there is physically no way for wage and salary earners to become investors because they get further and further behind as the relative purchasing power of their incomes declines with rising asset prices.

I am proposing that under current policy settings, the idea that "all" New Zealanders can invest in the stock market is a cruel confidence trick. At the moment the only people who can do so are those receiving and holding all those extra billions of unearned income introduced into the economy each year in the form of interest on the country's debt. Many if not most New Zealanders would choose to invest productively if they had a choice. Largely eliminating the interest burden would encourage them to do so. And inflation in the productive sector would be limited by lower wage pressures and production costs brought about by substantially reduced interest costs. Within this new financial structure, new lending will fall dramatically from its present levels because the interest on the total debt, the main component of new lending at present, will be substantially eliminated. And if new lending falls dramatically, so will inflation. However, to safeguard the transition, the government might choose to adopt lending guidelines and actively promote savings programmes to maintain a balance between consumption and savings.

Under these proposals, increased stock market participation by ordinary New Zealanders will become, for the first time, as safe as houses, allowing the goal of such investment by all New Zealanders to be realised.

Lowell Manning
28/1/08

ENDS

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